Answer:
The theory in question is Purchasing Power Parity (PPP), which suggests that exchange rates will adjust to equalize the cost of goods and services between two countries, reflecting the differences in inflation rates.
Step-by-step explanation:
The economic theory being described is known as Purchasing Power Parity (PPP). This theory asserts that with freely fluctuating exchange rates, the percentage change in exchange rates should be equal to the difference between the inflation rates of two countries. This means, effectively, that countries with higher inflation rates should see their currencies depreciate against countries with lower inflation rates. The concept of PPP is rooted in the notion that, in the long term, exchange rates will adjust to equalize the price of identical goods and services in any two countries.
The PPP exchange rate is a theoretical exchange rate that allows you to buy the same quantity of goods and services in any two countries. Economists use detailed studies of prices and quantities of internationally tradable goods to calculate the PPP exchange rates, which are then used to compare the relative economic outputs of different countries, taking into account the cost of living and inflation rates.