Question

If we assume that the purchasing power parity theory holds in the long run (as most economists do) then an increase in the U.S. relative price level by 5% would lead to which of the following in the long run?

	a.	No change in the amount of goods and services foreign currency could buy in the U.S.
	b.	Appreciation of the U.S. dollar by 5%
	c.	Increase the amount of goods and services foreign currency could buy in the U.S.
	d.	Depreciation of foreign currency by 5% against the U.S. Dollar

Answer 1

Answer) purchasing power parity holds when the purchasing power of a unit of currency is exactly equal in the domestic economy and in a foreign economy, once it is converted into foreign currency at the market exchange rate.

When prices rises the US currecy depreciates in order to hold the purchasing power parity. As a result, there will not be any change in the demand for goods and services in US.

So, option a) is correct.

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