The theory of purchasing power parity:
A) contradicts the law of one price.
B) explains exchange rate movements in the short run, while the law of one price explains exchange rate movements over the long run.
C) assumes away inflation to have any validity.
D) extends the law of one price to a basket of goods.

Question

Quizplus · Accepted Answer

The theory of purchasing power parity extends the law of one price to a basket of goods by comparing the prices of a representative basket of goods in different countries, taking into account the exchange rate between their currencies. This theory helps explain exchange rate movements over the long run by proposing that changes in the relative purchasing power of currencies will be reflected in their exchange rates.

The Theory of Purchasing Power Parity