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Solutions Chapter 4 Parity Conditions

Solutions Chapter 4 Parity Conditions - INSTRUCTORS MANUAL...

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INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT , 9TH ED. 1 CHAPTER 4 SUGGESTED ANSWERS TO CHAPTER 4 QUESTIONS 1. a. What is purchasing power parity? A NSWER . In its absolute version, purchasing power parity states that price levels should be equal worldwide when expressed in a common currency. In other words, a unit of home currency (HC) should have the same purchasing power around the world. The relative version of purchasing power parity, which is used more commonly now, states that the exchange rate between the home currency and any foreign currency will adjust to reflect changes in the price levels of the two countries. For example, if inflation is 5% in the United States and 1% in Japan, then the dollar value of the Japanese yen must rise by about 4% to equalize the dollar price of goods in the two countries. b. What are some reasons for deviations from purchasing power parity? A NSWER . PPP might not hold because: The price indices used to measure PPP may use different weights or different goods and services. Arbitrage may be too costly, because of tariffs and other trade barriers and high transportation costs, or too risky, because prices could change during the time that an item is in transit between countries. Since some goods and services used in the indices are not traded, there could be price discrepancies between countries. Relative price changes could lead to exchange rate changes even in the absence of an inflation differential. Government intervention could lead to a disequilibrium exchange rate. c. Under what circumstances can purchasing power parity be applied? A NSWER . The relative version of purchasing power parity holds up best in two circumstances: (a) over long periods of time among countries with a moderate inflation differential since the general trend in the price level ratio will tend to dominate the effects of relative price changes, and (b) in the short run during periods of hyperinflation since with high inflation changes in the general level of prices quickly swamp the effects of relative price changes. 2. One proposal to stabilize the international monetary system involves setting exchange rates at their purchasing power parity rates. Once exchange rates are correctly aligned (according to PPP), each nation would adjust its monetary policy so as to maintain them. What problems might arise from using the PPP rate as a guide to the equilibrium exchange rate? A NSWER . The proposal to adjust monetary policy so as to maintain purchasing power parity assumes that the PPP rate is the equilibrium rate. This assumption ignores the many shortcomings of PPP as a theory of exchange rate determination. Deviations from PPP have prevailed throughout the history of floating rate regimes. Thus there is good reason to believe that PPP provides a poor proxy for the equilibrium exchange rate at any point in time. If the PPP benchmark is used as a proxy for the equilibrium exchange rate when there are equilibrium departures from PPP, this guideline will interfere with long-run equilibration in the foreign exchange market. Here is the basic
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