If exchange rates adjust to reflect inflation differentials across countries,then:
A) the law of one price will always hold.
B) no one will use forward currency markets.
C) interest rates will be equal across countries.
D) PPP is said to hold.

Question

Quizplus · Accepted Answer

If exchange rates adjust to reflect inflation differentials across countries, then PPP (Purchasing Power Parity) is said to hold. PPP suggests that the exchange rate between two currencies should adjust to ensure that a basket of goods costs the same in both countries after accounting for the exchange rate. Therefore, fluctuations in inflation rates across countries can lead to adjustments in exchange rates to maintain the PPP, as the law of one price may not hold in reality, and interest rates may not be equal across countries in the short run. However, forward currency markets may still be used for hedging against currency risk.

If Exchange Rates Adjust to Reflect Inflation Differentials Across Countries,then