Economics • Economic BasicsHard
Analyze the concept of 'Purchasing Power Parity' in international economics. What does absolute purchasing power parity state regarding exchange rates between two countries?
A. The nominal exchange rate between two currencies should equal the ratio of price levels in the two countries, ensuring that a identical basket of goods costs the same everywhere when expressed in a common currency.✓ Correct Answer
B. Interest rate differentials between two nations must constantly offset expected changes in their bilateral nominal exchange rates.
C. Trade restrictions and transport costs are the primary determinants of long-term real exchange rate movements.
D. Central bank intervention in foreign exchange markets is necessary to maintain export competitiveness.
💡 Solution & Explanation
Absolute purchasing power parity asserts that exchange rates between currencies are in equilibrium when their purchasing power is roughly the same in each of the two countries. Consequently, the exchange rate reflects the relative price levels of a basket of goods in both nations, implying the absence of international arbitrage opportunities. Relative purchasing power parity relaxes this by stating that the percentage change in the exchange rate should equal the inflation differential between the two countries. Non-tradable goods and trade barriers frequently cause deviations from absolute purchasing power parity in empirical studies.
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