Chapter 6

Question 1

Purchasing Power Parity

Answer 1

Assumes the actions of importers and exporters induce changes on the spot exchange rate - suggests transactions on a country’s current account affect the market value of the exchange rate on the Forex market

Question 2

Law of one price (LoOP)

Answer 2

identical goods should sell for the same price in separate markets when there are no transportation costs and no differential taxes applied

Question 3

What is the likely market outcome when an arbitrage opportunity related to price discrepancies between two locations exists?

Answer 3

The prices in both locations will eventually converge due to increased buying and selling activities.

Question 4

How does the Purchasing Power Parity (PPP) theory explain the impact of a cheaper U.S. market basket on currency demand in the Forex market?

Answer 4

An increase in demand for the dollar by Mexican importers and an increase in peso supply by U.S. exporters.

Question 5

What are four primary reasons why the PPP theory condition is rarely satisfied IRL?

Answer 5

1. Transportation costs and trade restrictions
2. Costs of non-tradable inputs
3. (Im)Perfect information
4. Other market participants (international investors)

Question 6

How does a currency depreciation in a floating exchange rate system affect a country’s trade balance?

Answer 6

It can correct a trade deficit by making exports cheaper and imports more expensive.