Which of the following describes the purchasing power parity theory of exchange rate determination?
A) The exchange rate will adjust in the long run until the interest rate is roughly the same in both countries.
B) The exchange rate will adjust in the long run until real GDP per capita is roughly the same in both countries.
C) The exchange rate will adjust in the long run until the average price of goods is roughly the same in both countries.
D) The exchange rate will adjust in the short run until the average price of goods is roughly the same in both countries.
E) Prices adjust in the short run until the exchange rate is roughly the same in both countries.

Question

Quizplus · Accepted Answer

The purchasing power parity theory holds that the exchange rate between two countries will adjust in the long run until the average price of goods is roughly the same in both countries. This means that if one country has a higher average price level (inflation) than the other, its currency will depreciate in order to make its goods relatively cheaper and more attractive to buyers from other countries, and vice versa. This relationship is based on the idea that in a globalized market, the law of one price should hold, meaning that identical goods should have roughly the same price regardless of where they are sold. However, in reality, there are many factors that can influence exchange rates in the short run, such as interest rates, capital flows, political events, and market expectations, which can cause deviations from PPP.

Which of the Following Describes the Purchasing Power Parity Theory