Question #21
Reading: Reading 5 Currency Exchange Rates - Understanding Equilibrium Value
PDF File: Reading 5 Currency Exchange Rates - Understanding Equilibrium Value.pdf
Page: 8
Status: Unattempted
Question
Terrance Burnhart, a junior analyst at Wertheim Investments Inc., was discussing the concepts of purchasing power parity (PPP) and uncovered interest rate parity (UIRP) with his colleague, Francis Ferngood. During the conversation Burnhart made the following statements: Statement 1: Absolute PPP is based on a number of unrealistic assumptions that limits its real-world usefulness. These assumptions are: that all goods and services can be transported among countries at no cost; and all countries use the same basket of goods and services to measure their price levels. Statement 2: UIRP rests on the idea of equal real interest rates across international borders. Real interest rate differentials would result in capital flows to the higher real interest rate country, equalizing the rates over time. Another way to say this is that differences in interest rates are equal to differences in expected changes in exchange rates. With respect to these statements:
Answer Choices:
A. only statement 1 is correct
B. both are correct
Explanation
UIRP means that interest rates and exchange rates will adjust so the risk adjusted return
on assets between any two countries and their associated currencies will be the same. PPP
is based on the idea that a given basket of goods should cost the same in different
countries after taking into account the changes in exchange rates. PPP does not hold due
to transportation costs and other factors.