According to purchasing power parity (PPP) theory, a country with a high inflation rate will: A. export more goods to other countries B. see an appreciation in its currency exchange rate C. import more goods from other countries D. see depreciation in its currency exchange rate E. all F. none
The correct answer and explanation is:
The correct answer is: D. see depreciation in its currency exchange rate
Explanation:
Purchasing Power Parity (PPP) theory is an economic concept used to determine the relative value of different currencies. It states that in the long run, exchange rates should adjust so that identical goods cost the same in different countries when priced in a common currency. This theory relies heavily on the idea of inflation differentials between countries.
How does inflation affect exchange rates under PPP?
- When a country has a higher inflation rate compared to another country, the prices of goods and services in that country rise faster.
- As a result, domestic goods become relatively more expensive than foreign goods.
- This causes consumers and businesses in that country to buy more imported goods (since they are cheaper), leading to an increase in demand for foreign currency to pay for these imports.
- Simultaneously, foreign buyers find goods from the high-inflation country less attractive because of the rising prices, reducing demand for that country’s exports and thus its currency.
- Consequently, the country’s currency depreciates relative to the currencies of countries with lower inflation, meaning the exchange rate moves such that the domestic currency buys less foreign currency.
This depreciation helps restore purchasing power parity by making the country’s exports cheaper and imports more expensive over time, eventually balancing out the inflation differences.
Why the other options are incorrect:
- A. Export more goods to other countries: Usually, high inflation makes exports less competitive because goods become more expensive.
- B. See an appreciation in its currency exchange rate: Appreciation means the currency strengthens, which contradicts PPP theory when inflation is high.
- C. Import more goods from other countries: While high inflation may lead to more imports due to relatively cheaper foreign goods, this alone is not the primary effect; the key focus of PPP theory is on the exchange rate adjustment.
- E. All and F. None are obviously not correct because only option D fits the PPP theory prediction.
Summary:
According to PPP theory, a country experiencing high inflation will tend to see its currency depreciate in exchange rate terms to offset the inflation differential. This depreciation helps to maintain equilibrium in the relative purchasing power of currencies between countries over the long run.