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

Question

BlackTom AI · Accepted Answer

Purchasing-power parity (PPP) states that identical goods should cost the same in different countries when prices are expressed in a common currency, so relative price levels and exchange rates are linked over time.

1) Relevant knowledge points and concepts
- Absolute PPP: E = P_domestic / P_foreign, where E is the nominal exchange rate (domestic currency per unit of foreign currency), P denotes price levels. This implies identical goods have same price once converted.
- Relative PPP: links changes (rates of change) rather than levels: percentage change in E ≈ inflation_domestic − inflation_foreign. It is a long-run relationship; short-run deviations occur because of transaction costs, nontraded goods, tariffs, and sticky prices.

2) Step-by-step reasoning
- Start with absolute PPP: E_t = P_t(domestic) / P_t(foreign).
- Move to relative form to express growth: E_{t+1}/E_t = [P_{t+1}(dom)/P_t(dom)] / [P_{t+1}(for)/P_t(for)].
- Recognize P_{t+1}/P_t = 1 + inflation rate. So E_{t+1}/E_t = (1 + π_domestic)/(1 + π_foreign).

3) Intermediate calculation steps (approximation)
- For small inflation rates, use approximation: percentage change in E ≈ π_domestic − π_foreign.
- Example: if domestic inflation = 6% and foreign = 2%, expected depreciation ≈ 4%.

4) Why the correct answer is correct
- The choice "it suggests that changes in relative price levels drive changes in exchange rates in the long run" exactly describes relative PPP: inflation differentials drive exchange-rate adjustments over time to restore price parity.

5) Why other options are incorrect
- "It is always true and results in an exact mathematical relationship..." is false: PPP is an ideal benchmark; empirical deviations occur due to transport costs, nontraded goods, market frictions, and short-run monetary dynamics.
- "It is an application of the law of demand" is incorrect: the law of demand concerns quantity demanded falling as price rises; PPP concerns price level ratios and exchange rates, not demand behavior.
- "All of these" cannot be true because the previous two statements are incorrect.

6) Conclusion
The correct answer is: it suggests that changes in relative price levels drive changes in exchange rates in the long run, which matches the provided answer.

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

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