Purchasing Power Parity Assumptions

Easy Currency Exchange Rates Exchange Rate Models

In the context of currency exchange rates, various models have been established to explain the behavior of exchange rates over time. One such model is the Purchasing Power Parity (PPP) theory, which suggests that in the long run, exchange rates will adjust to equalize the price levels of two countries. However, the model has certain limitations when applied over short periods.

Which of the following options describes a key assumption of the Purchasing Power Parity model?

Exchange rates are influenced by interest rates and capital flows.

Goods are identical and can be traded freely between countries.

There are no transaction costs or barriers to trade.

Hint

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