If exchange rates adjust to reflect inflation differentials across countries,then:
A) the law of one price is wrong.
B) spot and forward rates will be equal.
C) nominal interest rates will be equal across countries.
D) purchasing power parity holds.

Question

Quizplus · Accepted Answer

If exchange rates adjust to reflect inflation differentials across countries, it implies that purchasing power parity holds. In other words, exchange rates adjust to compensate for the differences in prices between countries to ensure that the same basket of goods costs the same in both countries. This leads to the elimination of arbitrage opportunities and an equalization of prices across countries. Therefore, option D is the correct answer. Option A is incorrect because the law of one price is consistent with purchasing power parity. Option B is incorrect because spot and forward rates may not be equal due to differences in interest rates across countries. Option C is incorrect because nominal interest rates may differ across countries depending on their macroeconomic conditions, such as inflation and growth.

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