Macroeconomic Question?
The theory of purchasing power parity states that goods in different countries should cost the same amount in real terms. This theory implies that any changes in the exchange rate must reflect changes in the relative price levels across countries.
The following question focuses on the U.S. dollar-British pound exchange rate.
13.2. Purchasing power parity implies:
A. The exchange rate will approach $1 per unit of foreign currency in the long run
B. Countries with higher inflation rates will experience currency appreciation
C. Countries with lower inflation rates will experience currency depreciation
D. Changes in inflation rates are the major cause of exchange rate fluctuations
E. All these choices
Thanks in advance
Answer:
I agree that D is the right answer, but I also disagree with the previous responder on another issue. Exchange rates and Inflation are both key parts of the PPP relationship.
PPP states that
P1 = E * P2
where:
P1 is the average price level of goods in country 1
P2 is the average price level of goods in country 2
E is the exchange rate between the two countries.
Clearly, if P2 is increasing faster than P1, then the exchange rate must depreciate. That is, if country 2 has higher inflation then its exchange rate must be depreciating.
So, both B and C are incorrect.
The answer is D. If you can buy an apple in the US for $1 and the UK of .5 pounds in 2006 and in 2007 it costs $1.2 for that same apple it would cause the pound to appreciate.
A,B, & C deal with exchange rates - PPP isn't about exchange rates but rather specific supply and demand for goods and services in real terms.
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