Which is true about the purchasing-power-parity theory?

Question

BlackTom AI · Accepted Answer

Purchasing-power parity (PPP) states that identical goods should sell for the same price in different countries once prices are converted at the exchange rate, so relative price levels determine long-run exchange rate movements.

1. Relevant knowledge points and concepts
- Law of one price: identical tradable goods must have the same price across countries when expressed in a common currency, absent transport costs and trade barriers.
- Absolute PPP: price levels across countries should be equal when converted by the exchange rate.
- Relative PPP: changes in price levels (inflation differentials) drive proportional changes in exchange rates over the long run.
- Empirical status: PPP is a theoretical benchmark; in practice, deviations occur due to nontraded goods, transport costs, tariffs, and short-run financial factors.

2. Step-by-step reasoning
- PPP derives directly from the law of one price applied across a representative basket of goods (step from law-of-one-price to PPP).
- If country A’s price level rises faster than country B’s, relative PPP predicts A’s currency should depreciate to restore equal prices; thus inflation differentials cause exchange rate adjustments in the long run.
- Because real-world frictions and short-term capital flows can prevent immediate equalization, PPP is a theory (a long-run tendency) rather than a strict, always-true law.

3. Calculations
- No numeric calculation is required; the relationship is proportional: percentage change in exchange rate ≈ inflation differential (relative PPP).

4. Why the correct answer is correct
- Each listed statement is a true property of PPP: it is rooted in the law of one price, it predicts long-run exchange-rate adjustments driven by relative price changes, and it is a theoretical proposition not always observed exactly.

5. Why other options alone are incomplete or not contradictory
- “It is a theory so it is not proven nor always true” is true but partial.
- “It suggests that changes in relative price levels drive changes in exchange rates in the long run” is true but partial.
- “It is an application of the law of one price” is true but partial.
Selecting “all of these” correctly captures all three true, complementary statements.

6. Conclusion
All statements accurately describe PPP; therefore the correct answer is “all of these,” which matches the provided answer.

Which is true about the purchasing-power-parity theory?Single choice

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