12. Theories of Exchange Rate Determination

1. If the forecast UK inflation rate is 6% and the forecast European inflation rate is 2% and the spot exchange rate is €1.50/£1. Then according to relative PPP which of the following statements is correct?

The pound should appreciate by 4% to approximately €1.56/£1 The pound should depreciate by 4% to approximately €1.44/£1 The pound should appreciate by 8% to approximately €1.62/£1 The pound should depreciate by 8% to approximately €1.38/£1

2. If the UK interest rate is 7% and the US interest rate is 5% and the spot exchange rate is $1.80/£1. According to uncovered interest parity condition which of the following statements is correct?

The dollar-pound rate in one year’s time will be approximately $.1.836/£1 The dollar pound rate in one year’s time will be $1.7647/£1 The dollar-pound rate in one year’s time is expected to be $1.836/£1 The dollar pound rate in one year’s time is expected to be $1.7647/£1.

3. Which of the following statements concerning empirical research on Purchasing Power Parity (PPP) is FALSE?

PPP works better in the long run than in the short run. Deviations from PPP can be substantial and prolonged. PPP works better for non traded than traded goods. Exchange rates are generally more volatile than corresponding national inflation differentials.

4. If the UK inflation rate is forecast to be higher than the US inflation rate and the UK interest rate is higher than the US interest rate. Then which of the following statements is consistent with both PPP and UIP?

The pound is expected to depreciate against the dollar according to PPP and appreciate according to UIP. The pound is expected to appreciate against the dollar according to PPP and depreciate according to UIP. The pound is expected to appreciate against the dollar according to both PPP and UIP. The pound is expected to depreciate against the dollar according to both PPP and UIP.

5. Which one of the following does not appear as an explanatory variable in the monetary model of exchange rates?

Relative money supplies. Relative budget deficits. Relative inflation expectations. Relative real incomes.

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