Question

Assume a two-country world: Country A and Country B. Which of the following is correct about purchasing power parity (PPP) as related to these two countries?

a. If Country A's inflation rate exceeds Country B's inflation rate, Country A's currency will weaken.
b. If Country A's interest rate exceeds Country B's inflation rate, Country A's currency will weaken.
c. If Country A's interest rate exceeds Country B's inflation rate, Country A's currency will strengthen.
d. If Country B's inflation rate exceeds Country A's inflation rate, Country A's currency will weaken.

Answer 1

Option (a) is correct.

Step-by-step explanation:

Purchasing power parity measures the exchange rate between the two different currencies for the same quantity of goods. It is calculated by dividing the cost of goods in country A's currency by the cost of same quantity of goods in country B's currency.

If there is a rise in the inflation rate in country A, then this will increase the prices of good in country A. Therefore, the residents of country A pay higher amount for the same quantity of goods as compared to the other country.

Hence, there is a fall in the value of country A's currency.