Suppose that U.S. prices rise 4 percent over the next year while prices in Mexico rise 6 percent. According to the purchasing power parity theory of exchange rates, which of the following should happen?

Question

Quizplus · Accepted Answer

According to the purchasing power parity theory, if a country's inflation rate is higher than another's, its currency should depreciate. In this case, as Mexico has a higher inflation rate than the US, the peso should depreciate in relation to the dollar. Therefore, the correct answer is C. Option A and B are incorrect as they suggest that the dollar will depreciate or the peso will appreciate, which contradicts the theory. Option D is incorrect as it suggests that the dollar will appreciate, which is not supported by the theory.

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