Economics • Economic BasicsHard
In the context of international economics, what does the 'Purchasing Power Parity' (PPP) theory postulate regarding exchange rates between countries?
A. Exchange rates fluctuate purely based on speculative capital movements in financial markets
B. Nominal exchange rates between currencies equalize the purchasing power of different currencies by eliminating price level differences✓ Correct Answer
C. Trade deficits automatically correct themselves through central bank foreign reserve adjustments
D. Interest rate differentials dictate long-term capital flows between developed nations
💡 Solution & Explanation
Purchasing power parity theory asserts that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries, implying that a given basket of goods should cost the same everywhere when converted to a common currency. Absolute purchasing power parity equates price levels directly, while relative purchasing power parity accounts for inflation rate differentials over time. Transport costs, trade barriers, and non-tradable goods often cause deviations from purchasing power parity in the short run.
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