Understanding Purchasing Power Parity (PPP) in Exchange Rates

The exchange rate between two currencies can be influenced by various economic factors. One of the fundamental theories used to understand exchange rates is the Purchasing Power Parity (PPP) model. According to this model, the exchange rate between two currencies should equal the ratio of the price levels in the two countries.

For example, if a basket of goods costs $100 in Country A and the same basket costs €90 in Country B, the PPP suggests that the exchange rate should be 1.11 ($100/€90). If actual market exchange rates deviate significantly from this PPP value, it can lead to potential arbitrage opportunities.

Which of the following statements best describes the implications of the Purchasing Power Parity (PPP) model?