Suppose a basket of goods costs $400 in Canada and £200 in Britain.And suppose the exchange rate is $1/pound.According to the purchasing power parity theory, what will happen in the foreign exchange market?

Question

Quizplus · Accepted Answer

According to the purchasing power parity theory, the exchange rate should adjust to ensure that a basket of goods costs the same in different countries. In this case, the basket of goods is cheaper in Britain when converted to Canadian dollars, meaning that the exchange rate is not in equilibrium. As a result, an increase in demand for British pounds will lead to an increase in the price of pounds, as buyers seek to take advantage of the lower cost of goods in Britain. This will eventually lead to a correction in the exchange rate that brings it closer to parity with the purchasing power of each currency.

Suppose a Basket of Goods Costs $400 in Canada and £200