ANSWERS TO CHAPTER 4 QUESTIONS

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  1. a.   What is purchasing power parity?
  1. What are some reasons for deviations from purchasing power parity?
  1. Under what circumstances can purchasing power parity be applied?
  1. 2.   One proposal to stabilize the international monetary system involves setting exchange rates at their purchasing power parity 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?
  1. Suppose the dollar/rupiah rate is fixed but Indonesian prices are rising faster than U.S. prices. Is the Indonesian rupiah appreciating or depreciating in real terms
  1. Comment on the following statement. “It makes sense to borrow during times of high inflation because you can repay the loan in cheaper dollars.”
  1. 5.   Which is likely to be higher, a 150% ruble return in Russia or a 15% dollar return in the United States?
  1. 6.   The interest rate in England is 12%, while in Switzerland it is 5%. What are possible reasons for this interest rate differential? What is the most likely reason?
  1. From 1982 to 1988, Peru and Chile stand out as countries whose interest rates are not consistent with their inflation experience. Specifically, Peru’s inflation and interest rates averaged about 125% and 8%, respectively, over this period, whereas Chile’s inflation and interest rates averaged about 22% and 38%, respectively.
  1. How would you characterize the real interest rates of Peru and Chile (e.g., close to zero, highly positive, highly negative)?
  1. What might account for Peru’s low interest rate relative to its high inflation rate? What are the likely consequences of this low interest rate?
  1. What might account for Chile’s high interest rate relative to its inflation rate? What are the likely consequences of this high interest rate?
  1. During the same period, Peru had a small interest differential and yet a large average exchange rate change. How would you reconcile this experience with the international Fisher effect and with your answer to part b?
  1. From 1982 to 1988 a number of countries (e.g., Pakistan, Hungary, and Venezuela) had a small or negative interest rate differential and a large average annual depreciation against the dollar. How would you explain these data? Can you reconcile these data with the international Fisher effect?
  1. What factors might lead to persistent covered interest arbitrage opportunities among countries?
  1. 10. In early 1989, Japanese interest rates were about 4 percentage points below S. rates. The wide difference between Japanese and U.S. interest rates prompted some U.S. real estate developers to borrow in yen to finance their projects. Comment on this strategy.
  1. 11. In early 1990, Japanese and German interest rates rose while S. rates fell. At the same time, the yen and DM fell against the U.S. dollar. What might explain the divergent trends in interest rates?
  1. In late December 1990, one-year German Treasury bills yielded 9.1%, whereas one-year U.S. Treasury bills yielded 6.9%. At the same time, the inflation rate during 1990 was 6.3% in the United States, double the German rate of 3.1%.
  1. Are these inflation and interest rates consistent with the Fisher effect?
  1. What might explain this difference in interest rates between the United States and Germany?
  1. 13. The spot rate on the euro is $1.39, and the 180-day forward rate is $41. What are possible reasons for the difference between the two rates?
  1. 14. German government bonds, or Bunds, currently are paying higher interest rates than comparable U.S. Treasury bond Suppose the Bundesbank eases the money supply to drive down interest rates. How is an American investor in Bunds likely to fare?
  1. 15. In 1993 and early 1994, Turkish banks borrowed abroad at relatively low interest rates to fund their lending at hom The banks earned high profits because rampant inflation in Turkey forced up domestic interest rates. At the same time, Turkey’s central bank was intervening in the foreign exchange market to maintain the value of the Turkish lira. Comment on the Turkish banks’ funding strategy.
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