Movement Toward Exchange Rate Equilibrium in PPP

Very Hard Currency Exchange Rates Parity Conditions

In an open economy, the relationship between nominal exchange rates and price levels in two different countries can be described by the theory of purchasing power parity (PPP). According to PPP theory, if the price level in the domestic country is higher than in the foreign country, the domestic currency should depreciate to restore equilibrium in purchasing power between the two countries.

Assume Country A has a price level of 120 and Country B has a price level of 100. If the nominal exchange rate is currently 1.2 (A/B), which of the following conditions would suggest a movement towards equilibrium as per the PPP theory?

The exchange rate increases to 1.3 (A/B) as the price level in Country A rises to 130.

The exchange rate decreases to 1.1 (A/B) when the price level in Country A remains at 120 and Country B's price level increases to 110.

The exchange rate remains at 1.2 (A/B) while the price levels in both countries increase by 10%.

Hint

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