The purchasing power parity theory (PPP) of the exchange rate holds that if is the nominal exchange rate, P is the domestic price level and Pf is the foreign price level, then

Question

The purchasing power parity theory (PPP) of the exchange rate holds that if  is the nominal exchange rate, P is the domestic price level and Pf is the foreign price level, then

Quizplus · Accepted Answer

Option A is correct because if Pf grows faster than P, it means that the foreign currency is appreciating in value, and therefore there will be an increase in the nominal exchange rate to reflect this change in value.

Option B is also correct because according to the PPP theory, the exchange rate should be equal to the ratio of the foreign price level to the domestic price level.

Option C is incorrect because the real exchange rate is determined by adjusting the nominal exchange rate by the ratio of domestic and foreign price levels, so it can vary in response to changes in these price levels.

The Purchasing Power Parity Theory (PPP) of the Exchange Rate