Question

Suppose that the dollar/franc exchange rate equals \(\$ 0.50\) per franc. According to the purchasing- power-parity theory, what will happen to the dol- lar's exchange value under each of the following circumstances? a. The U.S. price level increases by 10 percent and the price level in Switzerland stays constant. b. The U.S. price level increases by 10 percent and the price level in Switzerland increases by 20 percent. c. The U.S. price level decreases by 10 percent and the price level in Switzerland increases by 5 percent. d. The U.S. price level decreases by 10 percent and the price level in Switzerland decreases by 15 percent.

Short answer

a. The dollar's value of exchange will depreciate. b. The dollar's value of exchange will appreciate. c. The dollar's value of exchange will appreciate. d. The dollar's value of exchange will depreciate.

Step-by-step solution

Understanding Purchasing Power Parity

The Purchasing Power Parity (PPP) theory states that the exchange rate between two countries should be equal to the ratio of their relative price levels. Hence, when price levels change, the PPP theory suggests that the exchange rate adjusts to maintain this equilibrium.

Scenario a: U.S. price level increases by 10% and Swiss level stays constant

In this case, the ratio of U.S. to Swiss price level has increased. To maintain balance, the dollar should depreciate relative to the franc, meaning the exchange rate (dollar per franc) should increase.

Scenario b: U.S. price level increases by 10% and Swiss level increases by 20%

Here, the Swiss price level has risen relative to the U.S. level, so by PPP theory, the dollar should appreciate relative to the franc, hence, the exchange rate (dollar per franc) decreases.

Scenario c: U.S. price level decreases by 10% and Swiss level increases by 5%

Since the U.S. price level decreases and the Swiss level increases, the dollar should appreciate relative to the franc, hence, the exchange rate (dollar per franc) should decrease.

Scenario d: U.S. price level decreases by 10% and Swiss level decreases by 15%

In this situation, the ratio of U.S. to Swiss price level has decreased. To maintain equilibrium, the dollar should depreciate relative to the franc, leading to an increase in the exchange rate (dollar per franc).

Key concepts

Exchange Rate

The concept of an exchange rate is central to international economics and finance. It specifies the value of one currency in terms of another. For instance, if the exchange rate between the dollar and the franc is \(\$0.50\) per franc, this means that one franc can be exchanged for half a dollar.

When discussing exchange rates, there are two types often mentioned: nominal and real exchange rates. The nominal exchange rate is the rate at which currencies are actually traded in the foreign exchange market, like our given example. In contrast, the real exchange rate adjusts the nominal rate to account for differences in price levels between countries, providing a measure of the relative purchasing power of the currencies.

Understanding how exchange rates are determined and influenced by various factors is essential. Market forces such as demand and supply, interest rates, and economic growth all play a role. Also, government actions through monetary policies can impact currency values. These rates are not static; they fluctuate in accordance with economic conditions and market perceptions.

Price Level Changes

When we explore price level changes, we're talking about the average level of prices across a wide range of products and services within an economy over a period of time. Inflation is a common measure of this change, indicating an increase in the price level, whereas deflation points to a decrease.

According to purchasing power parity (PPP), price level changes in different countries can lead to adjustments in exchange rates. The PPP theory suggests that in the absence of transportation costs and barriers to trade like tariffs, two currencies will exchange at a rate that equalizes the price of identical goods and services in any two countries. So, if prices in one country rise faster than in another, its currency should depreciate to restore parity.

Inflation Impact on Currency

For example, if the U.S. experiences a 10% inflation rate while Switzerland's prices remain constant, this means that goods in the U.S. have become more expensive relative to goods in Switzerland. Consequently, the value of the dollar would be expected to fall in terms of the Swiss franc, making U.S. goods relatively cheaper and thus rebalancing trade.

Currency Appreciation and Depreciation

The terms currency appreciation and depreciation describe the rise and fall in the value of a currency relative to another. This change in value can significantly influence a country's import and export activities, and subsequently, its economic performance.

Appreciation occurs when the value of a currency increases, making imported goods cheaper and exports more expensive. This can happen for various reasons, such as when a country's economic outlook is positive, or its interest rates are higher compared to other countries, attracting more foreign investment.

Conversely, depreciation is when a currency's value decreases relative to others, making imports more expensive and exports cheaper. This could stem from negative economic reports, lower interest rates, or political instability, among others.

Real-World Application

Let's apply these concepts to our original exercise. Considering scenario (a), an increase in the U.S. price level by 10% with the Swiss price level staying constant would lead to a depreciation of the dollar. On the other hand, in scenario (c), a decrease in the U.S. price level coupled with an increase in the Swiss price level would cause the dollar to appreciate. The interplay of these various economic indicators is complex, but understanding these basic principles can help us predict currency movements and their underlying reasons.