According to purchasing power parity, the foreign exchange market will
A) adjust the value of the exchange rate to reflect differing inflation rates between nations.
B) result in a flow of dollars out of the United States whenever its rate of inflation is below that of other nations.
C) no longer demand dollars if the inflation rate in the United States exceeds that of other nations.
D) undervalue the dollar if inflation in the United States is greater than it is elsewhere.

Question

Quizplus · Accepted Answer

Purchasing power parity theory suggests that exchange rates should adjust to reflect differences in inflation rates between countries. When one country has a higher inflation rate than another, its currency should depreciate relative to the currency of the country with lower inflation in order to maintain parity in the prices of traded goods. Therefore, option A is the correct answer as it describes the mechanism through which the foreign exchange market adjusts for inflation differentials. The other options do not accurately reflect the role of purchasing power parity in the determination of exchange rates.

According to Purchasing Power Parity, the Foreign Exchange Market Will