What long-run behavior does Purchasing Power Parity imply about exchange rate movements?

• A. PPP explains long-run exchange rate movements to equalize the price of a standardized basket of goods across countries
• B. PPP suggests prices should be identical across countries at all times
• C. PPP is irrelevant to price levels
• D. PPP only applies to service sectors

Answer: (A)

Purchasing Power Parity looks at the long-run path of exchange rates as a mechanism to equalize the cost of a standard basket of goods across countries when prices are converted into a common currency. If inflation runs higher in one country, its currency should depreciate over time so that the same basket costs the same after exchange-rate adjustment; if inflation is lower, the currency should appreciate. This idea rests on the basic arbitrage idea that tradable goods should have the same price internationally when priced in the same currency.

So the best answer captures that PPP explains long-run exchange-rate movements in service of price-level equality for a standardized basket of goods. In the short run, prices won’t be identical everywhere due to non-tradables, frictions, and other market imperfections, and PPP is not about services in isolation.