The strong positive correlation between the size of an expected depreciation of a currency and the size of the deviation of the trade-weighted exchange rate from parity
A) is a short-term relationship based on interest rate parity.
B) is a long-term relationship based on purchasing power parity.
C) is a loose relationship that does not really stand up to the weight of empirical testing.
D) is a short-term relationship based entirely on the rigidity of prices in the short run.
E) none of the above.

Question

Quizplus · Accepted Answer

The correct answer is based on the concept of purchasing power parity (PPP), which is a long-term economic theory used to determine the equilibrium exchange rate between currencies. PPP suggests that in the long term, exchange rates should adjust so that identical goods in different countries have the same price when expressed in the same currency. A deviation from parity implies that a currency is either undervalued or overvalued, which, according to PPP, should correct over time through changes in the exchange rate. This correction process can involve expected depreciation or appreciation of a currency to return to parity, hence establishing a long-term relationship between the size of expected depreciation and the deviation from parity.

The Strong Positive Correlation Between the Size of an Expected