Economics • Economic BasicsHard
Evaluate the concept of 'Purchasing Power Parity' in international economics. What does absolute purchasing power parity state regarding exchange rates between two countries?
A. Exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries
B. Inflation differentials between trading nations are completely offset by nominal interest rate adjustments✓ Correct Answer
C. Nominal exchange rates fluctuate based solely on speculative capital flows in foreign exchange markets
D. Trade balances remain perpetually neutral regardless of tariff barriers and transportation costs
💡 Solution & Explanation
Absolute purchasing power parity maintains that a basket of goods should cost the same in different countries when expressed in a common currency, implying exchange rates adjust to equalize price levels. Relative purchasing power parity adjusts this concept by stating that the percentage change in the exchange rate equals the inflation differential between two nations. Transportation costs, trade barriers, and non tradable goods explain deviations from PPP in empirical studies. The Big Mac index published by The Economist offers a popular illustrative application of this principle.
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