Explain relative purchasing power parity and when it is expected to hold in the long run.

• A. Rate change equals inflation differential
• B. Rate change equals interest rate differential
• C. Rate change equals trade balance
• D. Rate change equals government deficit

Answer: (A)

Relative purchasing power parity says that the change in a currency’s value over time should reflect the difference in inflation between the two countries. If domestic prices rise faster than foreign prices, the domestic currency should depreciate so that price levels, when expressed in the same currency, reflect similar purchasing power. In practical terms, the expected percentage change in the exchange rate is about the inflation differential: the currency of the country with higher inflation tends to weaken by roughly how much its inflation exceeds the other country’s inflation. This is a long-run tendency because, over time, price levels adjust and the real exchange rate tends to stabilize. Short-run movements can deviate due to other factors like interest rates, capital flows, and demand for assets, but relative PPP explains why, in the long run, exchange-rate changes mirror inflation differences. For example, if domestic inflation is higher by 2 percentage points than foreign inflation, the domestic currency is expected to depreciate by about 2% over time.