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IAI Actuarial Core Principles · Business Economics · Balance of payments and exchange rates

Which of the following is a recognised reason why the exchange rate often deviates from the level implied by PPP in the short run?

Deviations arise because arbitrage in goods is imperfect: non-traded services, transport costs, tariffs and other trade barriers, and differing consumption baskets stop prices equalising across countries, so actual exchange rates can stray from PPP in the short run.

  1. ANon-traded goods and services, transport costs and trade barriers prevent full goods-market arbitrageCorrect
  2. BPPP only applies to countries with identical interest rates
  3. CExchange rates are fixed by law under PPP
  4. DInflation rates are always equal across countries
  5. Capital flows are always zero

Explanation

PPP relies on arbitrage in traded goods. Non-tradable services, transport costs, tariffs and differing baskets weaken this, so deviations arise. The other options misstate PPP or are untrue assumptions.

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