What is Purchasing Power Parity (PPP) and its long-run implication for exchange rates?

• A. Exchange rates adjust to equalize the price of a basket of identical goods across countries; in the long run, rates reflect relative price levels and inflation
• B. Exchange rates are determined solely by central bank mandates
• C. PPP implies exchange rates fixed forever
• D. PPP ignores inflation

Answer: (A)

Purchasing Power Parity is about the idea that, in the long run, identical goods should cost the same when measured in a common currency. That means exchange rates move so that a basket of goods has the same price everywhere after adjusting for the exchange rate. The long-run implication is that differences in price levels and inflation across countries are reflected in the exchange rate: if one country experiences higher inflation, its currency should gradually depreciate relative to others to restore parity. This view rules out the notion that exchange rates are determined solely by central bank choices or that they are fixed forever, and it also rejects the idea that PPP ignores inflation. For example, if country A has higher inflation than country B over time, A’s currency tends to weaken against B’s to keep the purchasing power of money comparable internationally.