The next questions refer to the following.
During a common base period, a basket of goods costs C$14,700 in Canada and US$10,000 in the US.
-If,in the following year,Canada experiences 5% inflation while the US experiences 3% inflation,purchasing power parity theory predicts that
A) the US dollar will appreciate until US$1 = C$1.50
B) the Canadian dollar will appreciate by 2% against the US dollar
C) in the long run, the nominal value of a US dollar will equal one Canadian dollar
D) in the long run, the real trade-weighted exchange rate will be C$2 = US$3
E) the Canadian dollar will depreciate indefinitely, until the currency is worthless

Question

Quizplus · Accepted Answer

The correct answer is A because purchasing power parity theory predicts that the exchange rate will adjust to equalize the price of a basket of goods in different countries. In this case, the basket of goods costs C$14,700 in Canada and US$10,000 in the US. If Canada experiences 5% inflation and the US experiences 3% inflation, then the price of the basket of goods in Canada will increase to C$15,435 and the price of the basket of goods in the US will increase to US$10,300. This means that the US dollar will need to appreciate until US$1 = C$1.50 in order to equalize the price of the basket of goods in both countries.

The Next Questions Refer to the Following