Final answer:
The correct relationship between domestic and foreign prices and the nominal exchange rate, when the real exchange rate equals one, is given by P = PFor / e nom, reflecting the concept of purchasing power parity (PPP).
Step-by-step explanation:
The question addresses the concept of the purchasing power parity (PPP) and its relationship with domestic and foreign prices including the nominal exchange rate. The correct answer to this question is A) P = PFor / enom. This equation suggests that when goods are traded freely among countries and the real exchange rate equals one, the domestic price level (P) will be equal to the foreign price level (PFor) divided by the nominal exchange rate (enom).
The PPP exchange rate is calculated to equalize the prices of internationally traded goods such as oil, steel, computers, and cars between countries. If the PPP is ignored, businesses might exploit the price differences to buy goods in a country where they are cheaper and sell them where they are expensive, thereby making a profit. This long-term equilibrium is what the PPP exchange rate aims to represent, ensuring that the value of goods remains consistent across different currencies.