FINC3011 Tutorial 4

Chapter 8 Questions

9. What is the real exchange rate, and how are fluctuations in the real exchange rate related to
deviations from absolute purchasing power parity?

Answer: The real exchange rate, say, of the dollar relative to the euro, is denoted RS(t,$/€). It is
defined as the nominal exchange rate multiplied by the ratio of the price levels:

RS(t,$/€) = S(t,$/€) × P(t,€)/P(t,$) = 1

Note that the real exchange rate would be 1 if absolute purchasing power parity held because the
nominal exchange rate, S(t,$/€), would equal the ratio of the two price levels, P(t,$)/P(t,€).
Similarly, if absolute PPP is violated, the real exchange rate is not equal to 1. Thus, fluctuations in
the deviations from absolute PPP are fluctuations in the real exchange rate.

E.g. Suppose that S(USD/EUR) = $1.50. Suppose that 1 Big Mac costs $7.50 in the USA and
costs 5 EUR anywhere in Europe. Then,

RS($/Euro) = ($1.50/1 Euro) x (5 Euro)/$7.50 = 1.00

Chapter 8 Problems

1. If the consumer price index for the United States rises from 350 at the end of a year to 365 at the
end of the next year, how much inflation was there in the United States during that year?

Answer: Price indexes are ratios of the price level in a given year to the price level in a base year.
Because the base year is the same in the two price indexes under consideration, we can take the
ratio of the two price indexes and find the rate of inflation over that year. The ratio is 365/350 =
1.0429, or an inflation rate of 4.29%.

3. Suppose that the price level in Canada is CAD16,600, the price level in France is EUR11,750,
and the spot exchange rate is CAD1.35/EUR.

a. What is the internal purchasing power of Canadian dollars?

Answer: It is probably best to calculate the purchasing power of CAD10,000. If we divide this
amount by the price level in Canada of CAD16,600, we find:

CAD10,000 / [CAD16,600/1 consumption bundle] = 0.6024 consumption bundles

b. What is the internal purchasing power of the euro in France?

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 EUR10,000 / [EUR11,750/1 consumption bundle] = 0.8511 consumption bundles

c. What is the implied exchange rate of CAD/EUR that satisfies absolute PPP?

Answer: The implied PPP exchange rate equates the internal purchasing power of the CAD to its
external purchasing power. This implies that the PPP exchange rate is the ratio of the Canadian
price level in Canadian dollars to the French price level in euros:

SPPP(CAD/EUR) = (CAD16,600/EUR11,750) = CAD1.4128 / EUR

d. Is the euro overvalued or undervalued relative to the Canadian dollar?

Answer: Because the actual exchange rate of CAD1.35/EUR is less than the PPP exchange rate,
the euro is undervalued on the foreign exchange market because it would have to strengthen to
move from CAD1.35/EUR to CAD1.4128/EUR.

e. What amount of appreciation or depreciation of the euro would be required to return the
actual exchange rate to its PPP value?

Answer: The exchange rate would move from its current value of CAD1.35/EUR to the PPP value
of CAD1.4128/EUR.
This would mean a percentage change = 1.4128/1.35 – 1 = 0.0466. This would be a 4.66%
appreciation of the Euro versus the Canadian dollar.

4. Suppose that the rate of inflation in Japan is 2% in 2009. If the rate of inflation in Germany
is 5% during 2009, by how much would the yen strengthen relative to the euro if relative
purchasing power parity is satisfied during 2009?

Answer: The approximately correct answer is that the yen should strengthen by the differential in
the rates of inflation, i.e. 5% - 2% = 3%.
The exact answer is found from equation (8.4) of the text, which incorporates a denominator
correction, and we get:

Since we are concerned about the strengthening of the yen, let the yen be the foreign currency (FC),
and let the euro be the domestic currency (DC). Then, the relative PPP formula states that the rate
of appreciation of the yen (the “FC” in this example) is:

Appreciation of the yen = (0.05 – 0.02)/(1+0.02) = 0.03/1.02 = 0.0294 or 2.94%

6. Suppose that you are trying to decide between two job offers. One consulting firm offers you
$150,000 per year to work out of its New York office. A second consulting firm wants you to
work out of its London office and offers you £100,000 per year. The current exchange rate is

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 $1.65/£. Which offer should you take, and why? Assume that the PPP exchange rate is
$1.40/£ and that you are indifferent between working in the two cities if the purchasing power of
your salary is the same.

Answer: We know from the extensive discussion in Question 8 that we should use the PPP
exchange rate to compare the pound salary to the dollar salary. If we do so, we find $1.40/£ x
£100,000 = $140,000. This is less than the $150,000 that you are being offered in New York. The
fact that the dollar is undervalued on the foreign exchange markets makes the perceived salary of
$1.65/£ x £100,000 = $165,000, calculated with the spot exchange rate, seem more attractive. But,
the key point is that to achieve $165,000 of spending in the United States, you would have to work
in London and consume in New York.

Chapter 10 Questions

2. Suppose that the international parity conditions all hold and a country has a higher nominal
interest rate than the United States. Characterize the country’s inflation rate compared to the
United States, the country’s expected exchange rate change versus the dollar, the country’s
currency forward premium versus the dollar, and the country’s real interest rate compared to the
U.S. real interest rate

Answer: When all the parity conditions hold, real interest rates are equalized across countries, so
the country’s real interest rate should equal that of the United States. The country’s higher nominal
interest rate therefore must reflect a higher expected rate of inflation relative to the United States.
Since the parity conditions hold, a higher expected rate of inflation implies that country’s currency
should be expected to depreciate relative to the dollar, and the currency will trade at a forward
discount relative to the dollar.

Chapter 10 Problems

1. Suppose the 1-year nominal interest rate in Zooropa is 9%, and Zooropa’s expected inflation rate
is 4%. What is the real interest rate in Zooropa?

Answer: the expected real interest rate is approximately 9% - 4% = 5%.

The correct (exact) computation is: (1+0.09)/(1+0.04) - 1 = 0.0481 = 4.81%.

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Supplementary questions:

Chapter 8 Questions

4. What do economists mean by the law of one price? Why might the law of one price be
violated?

Answer: The law of one price says that the price of a good, when denominated in a particular currency, is the
same wherever in the world the good is being sold. The law of one price relies on arbitrage in the goods
market. If the good is being sold in one place at a low price and is being sold in a different place at a high
price, people have an incentive to arbitrage the two markets. Therefore, anything that makes it difficult or
costly to arbitrage in the goods market can create a deviation from the law of one price.

Clearly, transaction costs, such as the costs of shipping, generate deviations from the law of one price that
cannot be arbitraged. Tariffs and quotas on imports and exports also create deviations. If markets are not
competitive and firms have some monopoly power, the corporation may decide to charge different prices in
different countries, but it must be able to segment the markets to prevent arbitrage. If arbitrage cannot be
done instantaneously, there will be a speculative element that enters the calculations and the speculator may
have to be compensated for the risk of loss with an expected profit from buying in one market and selling in
another market at a later point in time. Finally, various goods markets are subject to a certain amount of
price stickiness because of the costs of changing prices. Because exchange rates are asset prices and freely
flexible, unanticipated changes in exchange rates will create deviations from the law of one price if goods
prices are sticky.

5. What is the value of the exchange rate that satisfies absolute purchasing power parity?

Answer: Absolute purchasing power parity requires that the internal purchasing power of a currency equals
its external purchasing power. The internal purchasing power is calculated by taking the reciprocal of the
price level, and the external purchasing power is calculated by first exchanging the domestic money into the
foreign money in the foreign exchange market and then calculating the purchasing power of that amount of
foreign currency in the foreign country. Hence, the prediction of absolute PPP for the exchange rate of
domestic currency per unit of foreign currency is found by equating the internal purchasing power of the
domestic currency to the external purchasing power of the domestic currency:

1/PDC = (1/SPPP) x (1/PFC)

where PDC is the domestic price level, PFC is the foreign price level, and SPPP
signifies the exchange rate that satisfies the PPP relation. By solving for SPPP, we find:

SPPP = (PDC)/(PFC)

10. What is relative purchasing power parity, and why does it represent a weaker relationship
between exchange rates and prices than absolute purchasing power parity?

Answer: The theory of relative PPP specifies that exchange rates adjust in response to differences in inflation
rates across countries to leave the deviation of the actual exchange rate from absolute PPP unchanged.
Intuitively, inflation is the rate of loss of the internal purchasing power of a currency. Thus, if two currencies
are losing internal purchasing power at different rate because the rates of inflation in the two countries are
not equal, the rate of change of the exchange rate can offset the differential rates of inflation to leave the
same absolute relationship between the internal and external purchasing powers of the currencies. The
relative PPP theory is weaker than absolute PPP because relative PPP could be satisfied even though there
are deviations from absolute PPP. The requirement for relative PPP to hold is that the deviations from
absolute PPP do not change over time.

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Chapter 10 Questions

1. What is the difference between the ex-ante and the ex-post real interest rate?

Answer: The ex post interest rate corrects the nominal interest rate with the realized or ex post
rate of inflation; whereas the ex-ante (or expected) real interest rate corrects the nominal
interest rate for expected inflation.

As a lender, you care about the real return on your investment, which is the return that measures
your increase in purchasing power between two periods of time. If you invest $1, you sacrifice
$1 1+i
real goods now, where P(t) is the price level. In 1 year, you get back , where i is
P(t) P(t+1)
the nominal rate of interest. We calculate the real return by dividing the real amount you get
back by the real amount that you invest. Thus, if rep is the ex post real rate of return and ex post
real interest rate, we have
 1+i 
 P(t+1) 
1 + r ep =   = (1 + i )
 1   P(t+1) 
 P(t)   P(t) 
   

Notice that the real rate of interest depends on the realization of the rate of inflation because
P(t + 1)/P(t) = 1 + π(t + 1), where π(t + 1) is the rate of inflation between time t and t + 1. For
simplicity, we drop the time notation and simply write
(1 + i)
1 + r ep =
(1 + π)
If we subtract 1 from each side, we have
(1 + i) (1 + π) i-π
r ep = - =
(1 + π) (1 + π) (1 + π)
which is often approximated as
rep = i – π
The approximation involves ignoring the term (1 + π) in the denominator, which is close to 1
if inflation is not too high. Thus, the ex post real interest rate equals the nominal interest rate
minus the actual rate of inflation.

Because the inflation rate is uncertain at the time an investment is made, the lender cannot
know with certainty the real rate of return on the loan. By taking the expected value of both
sides of the equation, conditional on the information set at the time of the loan, we derive the
lender’s expected real rate of return, which is also called the expected real interest rate, or
the ex ante real interest rate, which we denote re:
r e = E t [r ep ] = i(t) - E t [π(t+1)]