Chapter 4 Int. Fin.

Shapiro & Sarin, Foundations of Multinational Financial Management, 6th Ed., © 2009 John Wiley & Sons, Inc. Reprinted with permission of John Wiley & Sons, Inc.

SUGGESTED ANSWERS TO CHAPTER 4 QUESTIONS 1.a. What is purchasing power parity (PPP)? ANSWER. In its absolute version, PPP states that price levels should be equal worldwide when expressed in a common currency. In other words, a unit of home currency (HC) should have the same purchasing power around the world. The relative version of PPP, which is used more commonly now, states that the exchange rate between the home currency and any foreign currency will adjust to reflect changes in the price levels of the two countries. For example, if inflation is 5% in the U.S. and 1% in Japan, the dollar value of the Japanese yen must rise by about 4% to equalize the dollar price of goods in the two countries. 1.b. What are some reasons for deviations from purchasing power parity? ANSWER. PPP might not hold because: • The price indices used to measure PPP may use different weights or different goods and services. • Arbitrage may be too costly because of tariffs and other trade barriers and high transportation costs, or too risky because prices could change during the time that an item is in transit between countries. • Since some goods and services used in the indices are not traded, there could be price discrepancies between countries. • Relative price changes could lead to exchange rate changes even in the absence of an inflation differential. • Government intervention could lead to a disequilibrium exchange rate. 1.c. Under what circumstances can PPP be applied?

ANSWER. The relative version of PPP holds up best in two circumstances: (a) over long periods among countries with a moderate inflation differential since the general trend in the price level ratio will tend to dominate the effects of relative price changes, and (b) in the short run during periods of hyperinflation since with high inflation changes in...