Given a home country and a foreign country, purchasing power parity suggests that: A. the home currency will depreciate if the current home interest rate exceeds the current foreign interest rate; B. the home currency will depreciate if the current home inflation rate exceeds the current foreign interest rate; C. the home currency will depreciate if the current home inflation rate exceeds the current foreign inflation rate. D. the home currency will appreciate if the current home inflation rate exceeds the current foreign inflation rate;

Question

Business

Rashad Ochoa

19 April, 19:08

Given a home country and a foreign country, purchasing power parity suggests that: A. the home currency will depreciate if the current home interest rate exceeds the current foreign interest rate; B. the home currency will depreciate if the current home inflation rate exceeds the current foreign interest rate; C. the home currency will depreciate if the current home inflation rate exceeds the current foreign inflation rate. D. the home currency will appreciate if the current home inflation rate exceeds the current foreign inflation rate;

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Answers (2)

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Thumper · Answer 1

C. The Home Currency will depreciate if current home Inflation rate exceeds current foreign inflation rate.

Explanation:

Purchasing Power Parity suggests that identical consumption basket of goods cost same in all nations, if measured in single currency denomination. So, Exchange rate between two countries = Price level Ratio b/w them. Example : ExRt ($/€) = Pr (US) / Pr (Europe) [Also called Law of One Price]. Ex - A Commodity basket costing 200$ in US & €160 in Europe would imply $/€ ex. rate = 200/160 = 1.25, implying equal price of commodity basket in both countries

It also states that changes in exchange rate are governed by changes in national price level. A country with relatively higher inflation rate depreciates, a country with relatively less inflation rate appreciates (depending on their domestic inflation rate differentials). Such happens to retain the 'Law of one Price' equality if either country's price level changes. Eg : If US price level triple to 600$, exchange rate would change to 600/160 = 3.75€ / $, implying inflation rise in US has increased exchange rate & devalued its currency.

Richard Steele · Answer 2

Option (C) is Correct.

Explanation:

There are two countries : Home country and Foreign country.

Purchasing power parity measures or compares the currencies of the two different nations by using a basket of goods approach.

It is calculated as follows:

= (cost of basket of goods in home currency) : (Cost of same basket of goods in foreign country)

We know that if there is an increase in the rate of inflation in a home country then as a result there is a fall in the value of home currency. Higher inflation will lead to an increase in the prices of goods in the home country but prices remains the same in foreign country.