According to the PPP theory of exchange rates, the nominal exchange rate is expected to appreciate if:Group of answer choicesdomestic inflation is higher than foreign inflationthe foreign price level is above the domestic price levelforeign inflation is higher than domestic inflationthe domestic price level is above the foreign price level
Question
According to the PPP theory of exchange rates, the nominal exchange rate is expected to appreciate if:Group of answer choicesdomestic inflation is higher than foreign inflationthe foreign price level is above the domestic price levelforeign inflation is higher than domestic inflationthe domestic price level is above the foreign price level
Solution
According to the Purchasing Power Parity (PPP) theory of exchange rates, the nominal exchange rate is expected to appreciate if foreign inflation is higher than domestic inflation.
Here's a step-by-step explanation:
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The PPP theory states that the exchange rate between two countries should equal the ratio of the two countries' price levels.
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If the foreign inflation is higher than the domestic inflation, it means that the price level in the foreign country is increasing at a faster rate than in the domestic country.
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As a result, the foreign currency is losing its purchasing power relative to the domestic currency.
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To maintain the balance, the exchange rate will adjust, causing the domestic currency to appreciate relative to the foreign currency.
So, the correct answer is: "foreign inflation is higher than domestic inflation".
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