If exchange rates adjust to reflect inflation differentials across countries, then:

Question

Quizplus · Accepted Answer

If exchange rates adjust to reflect inflation differentials across countries, it means that purchasing power parity (PPP) holds. PPP is a theory that suggests changes in exchange rates between two countries' currencies should equalize the price of a basket of goods and services between the two countries. Therefore, Option D is the correct answer. Option A is incorrect because the law of one price is not necessarily voided by different inflation rates. Option B is incorrect because spot and forward rates may not necessarily be equal even if exchange rates adjust for inflation differentials. Option C is incorrect because nominal interest rates can differ across countries even if exchange rates adjust for inflation differentials.

If Exchange Rates Adjust to Reflect Inflation Differentials Across Countries