3.7. TEST YOUR UNDERSTANDING 119
- Purchasing Power Parity is based on the idea that the demand for a country’s
currency is derived from the demand for that country’s goods as well as the
currency itself.
Multiple-Choice QuestionsChoose the correct answer(s).
- CPPmay not hold because:
(a) the prices for individual goods are sticky.
(b) transaction costs increase the bounds on deviations fromCPP, making it
more difficult to arbitrage away price differences.
(c) quotas and voluntary export restraints limit the ability to arbitrage across
goods markets.
(d) parallel imports lead to two different prices for the same good.
(e) the prices of tradable goods fluctuate too much, which makes it difficult
to take advantage of arbitrage opportunities.- Absolute Purchasing Power Parity may not hold when:
(a) the prices of individual goods in the consumption bundle consistently
deviate fromCPPacross two countries.
(b) the consumption bundles of different countries are not the same.
(c) the prices for individual goods are sticky.
(d) there are tariffs, quotas, and voluntary export restraints.
(e) competition is perfect. - Relative Purchasing Power Parity is relevant because:
(a) empirical tests have shown that AbsolutePPPis always violated, while
RelativePPPis a good predictor of short-term exchange rate exposure.
(b) consumption bundles are not always comparable across countries.
(c) price levels are not stationary over time.
(d) investors care about the real return on their international portfolio in-
vestments.
(e) investors care about the nominal return on their international portfolio
investments.2.6.2 Applications
- You have just graduated from the University of Florida and are leaving on
a whirlwind tour to see some friends. You wish to spendusd1,000 each in
Germany, New Zealand, and Great Britain (usd3,000 in total). Your bank
offers you the following bid-ask quotes:usd/eur1.304-1.305,usd/nzd0.67-
0.69, andusd/gbp1.90-1.95.