The mechanism behind the inflation insulation provided by a floating exchange rate is
A) Purchasing Power Parity.
B) a fixed AA curve.
C) market speculation.
D) tight monetary policy.
E) symmetry.

Question

Quizplus · Accepted Answer

Purchasing Power Parity suggests that goods and services should have the same price across different countries when converted into a common currency. If inflation in one country causes its currency to depreciate, then its goods become relatively cheaper, leading to an increase in demand for its exports and a decrease in demand for imports. This should help reduce inflationary pressure in the country as it limits the price increase of imported goods. A floating exchange rate can allow for the necessary adjustments in exchange rates to achieve PPP and thereby insulate against inflation.

The Mechanism Behind the Inflation Insulation Provided by a Floating