Question

Purchasing- power parity theory:

a. would be entirely accurate if only goods were traded.
b. is a completely accurate description of the real world.
c. provides a reason to expect that movements in the real exchange rate will typically be small or temporary.
d. would be entirely accurate if all consumers had the same preferences.

Answer 1

The purchasing power parity (PPP) theory is related to how exchange rates stabilize in the long term based on purchasing power for internationally traded goods. Option 'c' correctly states that PPP suggests movements in real exchange rates are generally small or temporary.

Step-by-step explanation:

The purchasing power parity (PPP) theory states that over the long term, exchange rates should align with the currency's buying power in terms of internationally traded goods. The concept of PPP suggests that businesses will exploit price differences by purchasing goods in a country where they are cheaper and selling them in a country where they are more expensive, thus pocketing the profits. This arbitrage process would push the exchange rates towards the point where no further profit can be made from these activities, known as PPP exchange rate. Answering the question, option 'c' provides a reason to expect that movements in the real exchange rate will typically be small or temporary is correct because PPP assumes that in the absence of transportation costs and barriers to trade, arbitrage forces will align exchange rates to reflect the true value of currencies based on their purchasing power of goods.