Q: Which equation represents the real exchange rate between the US and Europe?

$$q = E_{\$$/€} \times \frac{P_{EU}}{P_{US}}$

Question 1

According to the law of one price, what should happen if a Big Mac costs $$4.00 in the US and 6.00 in $$Canada, and there are no transportation costs or trade barriers?

Accepted Answer

Entrepreneurs will buy Big Macs in the US and sell them in Canada, causing the price in the US to rise and the price in Canada to fall until they are equal in a common currency.

Question 2

If the price level in the US is $$200 and in Canada is 400$$, what does absolute purchasing power parity (PPP) predict for the CAD/USD exchange rate?

Accepted Answer

$$2 	ext{ CAD/USD}$$

Question 3

Which of the following best explains why absolute PPP often fails in the real world?

Accepted Answer

Non-tradable goods, trade barriers, and differences in consumption baskets across countries.

Question 4

Suppose the US increases its money supply growth rate permanently. According to the monetary approach and the Fisher effect, what happens to the US nominal interest rate and the dollar/euro exchange rate in the long run?

Accepted Answer

Both the US nominal interest rate and the dollar/euro exchange rate increase by the same amount as the increase in the money supply growth rate.

Question 5

If tariffs raise the cost of imported goods in Canada, what is the most likely short-run effect on the real exchange rate $$q = E 	imes \frac{P_{US}}{P_{CA}}$$?

Accepted Answer

The real exchange rate appreciates, even if the nominal exchange rate does not change.

Question 6

Relative PPP states that:

Accepted Answer

The rate of change in the exchange rate equals the inflation differential between two countries.

Question 7

Which equation represents the real exchange rate between the US and Europe?

Accepted Answer

$$q = E_{\$$/€} 	imes \frac{P_{EU}}{P_{US}}$

Question 8

A permanent increase in US productivity (output supply) will have what effect on the real exchange rate and the nominal exchange rate, according to the real exchange rate approach?

Accepted Answer

The real exchange rate depreciates, but the effect on the nominal exchange rate is ambiguous.

Question 9

According to the Fisher effect, if expected inflation in the US rises by 2% while European inflation remains unchanged, what happens to the US nominal interest rate in the long run?

Accepted Answer

It rises by 2%.

Question 10

If the actual CAD/USD exchange rate is 1.3 and the implied PPP from the Big Mac Index is 1.5, what does this suggest about the Canadian dollar?

Accepted Answer

The Canadian dollar is overvalued relative to the US dollar.

Question 11

Which of the following is NOT a reason why the law of one price may fail in practice?

Accepted Answer

Perfect competition in all markets.

Question 12

If the US nominal interest rate is higher than Japan's, and investors engage in carry trades, what risk could quickly reverse the flow and cause the USD/JPY exchange rate to move sharply?

Accepted Answer

A sudden increase in volatility or hedging costs.

Question 13

Which formula best expresses the Fisher effect?

Accepted Answer

$$R = r + \pi^e$$

Question 14

If the US price level jumps upward due to an increase in expected future inflation, what must happen to the dollar/euro exchange rate under the flexible-price monetary approach?

Accepted Answer

The dollar must depreciate against the euro.

Question 15

Which of the following best describes the relationship between real interest rates and real exchange rates in the long run?

Accepted Answer

Differences in real interest rates are equal to the expected change in the real exchange rate.

Question 16

Which of the following is a key insight from the real exchange rate approach to exchange rates?

Accepted Answer

Both monetary and real factors (like productivity and demand) influence nominal exchange rates.

Question 17

If the US increases its money supply but prices are sticky in the short run, what is likely to happen to the exchange rate according to the long-run model without PPP?

Accepted Answer

The exchange rate overshoots, causing the dollar to depreciate more than its long-run value.

Question 18

Which of the following is a real-world example used to illustrate PPP and the law of one price?

Accepted Answer

The Big Mac Index.

Question 19

If the US price level falls relative to the EU price level, what happens to the real exchange rate $$q = E_{\$$/€} 	imes \frac{P_{EU}}{P_{US}}$ if the nominal exchange rate is unchanged?

Accepted Answer

The real exchange rate increases (real depreciation of the dollar).

Price Levels and the Exchange Rate in the Long Run

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