Final answer:
The empirical evidence suggests that higher inflation rates in a country lead to greater depreciation of its currency in relation to purchasing power parity theory. Over time, exchange rates tend to adjust to align with PPP, which equates the prices of internationally traded goods across countries. Option C is correct.
Step-by-step explanation:
The empirical evidence on purchasing power parity (PPP) over the long run seems to indicate that the higher a country's inflation rate, the greater is the depreciation in the country's currency. This is because, in the medium term of a few months or a few years, inflation rates influence exchange rate markets.
Countries with relatively high inflation tend to see lower demand for their currency compared to countries with lower inflation, leading to currency depreciation. However, over long periods, exchange rates generally adjust towards the PPP rate, which aligns the prices of internationally tradable goods across different countries when converted to a common currency.
Thus, PPP suggests that exchange rates must bear some relationship to the currency's buying power in terms of internationally traded goods. If goods were much cheaper in one country due to the exchange rate, businesses would capitalize on this by buying in the cheaper country and selling in other countries, ultimately impacting the exchange rates further towards parity.