Implications of PPP in Currency Exchange Rate Determination

Hard Currency Exchange Rates Exchange Rate Models

In 2023, the global economy is experiencing fluctuations in currency values, with particular focus on the relationship between the US dollar (USD) and the euro (EUR). Analysts have employed several exchange rate models to forecast currency movements. One of these models emphasizes the significance of relative price levels in influencing exchange rates over the long run, suggesting that currencies adjust to changes in inflation rates.

According to Purchasing Power Parity (PPP), the exchange rate between two currencies should adjust to reflect changes in price levels in the respective countries. If the inflation rate in Eurozone countries is significantly higher than that in the United States, this model would predict a depreciation of the euro against the dollar. However, some critics point out that PPP holds in the long run but may not accurately predict short-term fluctuations due to market imperfections.

Based on this scenario, which of the following statements best reflects the implications of the PPP model in currency exchange rate determination?

The PPP model is primarily used for short-term trading strategies that capitalize on immediate currency valuations.

The PPP model predicts that currencies move towards an equilibrium exchange rate based on relative price levels in the long run.

The PPP model suggests that the exchange rate is only influenced by interest rate differentials between two countries.

Hint

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