Question

6) Assume that U.S. and British investors require a real return of 3%. If the nominal U.S.
interest rate is 16%, and the nominal British interest rate is 13%, then according to the
Real Interest Parity (RIP) as well as the Uncovered Interest Parity (UIP), the British
inflation rate is expected to be about _________ the U.S. inflation rate, and the British
pound is expected to _________.
A. 3 percentage points above; appreciate by about 3%
B. 3 percentage points below; appreciate by about 3%
C. 3 percentage points above; depreciate by about 3%
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D. 3 percentage points below; depreciate by about 3%
E. None of the above is true.
7) If the actual exchange rate for the euro value of US dollar is greater than the exchange
rate that would satisfy absolute purchasing power parity, then which one of the following
statements is MOST likely to be correct?
A. The US dollar is undervalued (relative to the euro).
B. The euro is overvalued (relative to the US dollar).
C. The internal purchasing power of the US dollar is less than its external purchasing
power.
D. Change in the internal purchasing power of the US dollar will be less than change in
its external purchasing power.
E. The price level in US is relatively lower than the price level in Europe.

8) The inflation rates in the US and Europe in the last year are equal. Suppose the real
exchange rate RS(USD/EUR) has increased from 0.85 to 0.95 in the last year. Which of
the following statements is LEAST likely to be correct?
A. Absolute purchasing power parity has been violated.
B. Relative purchasing power parity has been violated.
C. The Euro dollar has a real appreciation against the US dollar.
D. The nominal exchange rate S(USD/EUR) should remain unchanged.
E. Loss of the internal purchasing power of the Euro is different from loss of its external
purchasing power.

Answer 1

6. The real interest rate, nominal interest rate and inflation rate are related as

(1+ nominal interest rate) = (1+ real interest rate) * (1+ inflation rate)

So, Inflation rate in US = 1.16/1.03 -1 = 0.126214 or 12.62%

Inflation rate in Britain = 1.13/1.03 -1 = 0.097087 or 9.71%

The currency with lower inflation/ interest rate appreciates against the currency with higher inflation/ interest rate

So, according to the Real Interest Parity (RIP) as well as the Uncovered Interest Parity (UIP), the British
inflation rate is expected to be about 3% above the U.S. inflation rate and the British pound is expected to appreciate by approximately 3% (option A is correct)