international-finance-exercise-for-chapter-8 - Answers to End of Chapter 8s Questions 1 PPP suggests that the purchasing power of a consumer will be

international-finance-exercise-for-chapter-8 - Answers to...

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Answers to End of Chapter 8’s Questions 1. PPP suggests that the purchasing power of a consumer will be similar when purchasing goods in a foreign country or in the home country. If inflation in a foreign country differs from inflation in the home country, the exchange rate will adjust to maintain equal purchasing power. Currencies in countries with high inflation will be weak according to PPP, causing the purchasing power of goods in the home country versus these countries to be similar. 5. PPP does not consistently hold because there are other factors besides inflation that influences exchange rates. Thus, exchange rates will not move in perfect tandem with inflation differentials. In addition, there may not be substitutes for traded goods. Therefore, even when a country’s inflation increases, the foreign demand for its products will not necessarily decrease (in the manner suggested by PPP) if substitutes are not available. 6. The IFE suggests that a currency’s value will adjust in accordance with the differential in interest rates between two countries. The rationale is that if a particular currency exhibits a high nominal interest rate, this may reflect a high anticipated inflation. Thus, the inflation will place downward pressure on the currency’s value if it occurs. The implications are that a firm that consistently purchases foreign Treasury bills will on average earn a similar return as on domestic Treasury bills. The IFE may not hold because exchange rate movements react to other factors in addition to interest rate differentials. Therefore, an exchange rate will not necessarily adjust in accordance with the nominal interest rate differentials, so that IFE may not hold. 7. The IFE would suggest that the U.S. dollar will depreciate over time if U.S. interest rates are currently higher than foreign interest rates. Consequently, foreign investors who purchased U.S. securities would on average receive a similar yield as what they receive in their own country, and U.S. investors that purchased foreign securities would on average

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