According to purchasing power parity (PPP), if domestic inflation is higher than foreign inflation, what should happen to the domestic currency?

• A. It should depreciate
• B. It should appreciate
• C. It should remain stable
• D. It should become volatile

Answer: (A)

Purchasing power parity says exchange rates move so that a common basket of goods has the same price in every country when expressed in a common currency. If domestic inflation is higher than foreign inflation, the domestic price level rises faster, making domestic goods relatively more expensive. To restore parity, the exchange rate should adjust so that domestic prices align with foreign prices, which means the domestic currency must lose value. In relative PPP terms, the expected depreciation of the domestic currency approximates the difference between domestic and foreign inflation; a higher domestic inflation rate implies a weaker (depreciated) domestic currency. PPP is a long-run tendency, so this depreciation direction is the typical outcome, even though real-world rates can deviate in the short run due to other forces.