Suppose inflation is higher in Canada over the next few months than in foreign countries, and exchange rates are given in terms of how much foreign currency a dollar buys or how many foreign goods Canadian goods buy. According to purchasing-power parity, what should we expect to see?
A) Only the nominal exchange rate depreciates.
B) Both the real and nominal exchange rates appreciate.
C) Both the real and nominal exchange rates depreciate.
D) Only the real exchange rate appreciates.

Question

Quizplus · Accepted Answer

According to purchasing-power parity, if inflation is higher in Canada than in foreign countries, the Canadian dollar should depreciate in value relative to foreign currencies. This is because the higher inflation in Canada will make Canadian goods and services more expensive relative to foreign goods and services, making it more expensive for foreigners to buy Canadian goods and services and cheaper for Canadians to buy foreign goods and services. As a result, the demand for Canadian dollars will decrease, and the supply of Canadian dollars will increase, leading to a depreciation in the value of the Canadian dollar.

Suppose Inflation Is Higher in Canada Over the Next Few