If a nation experiences 10% inflation and its trading partner does not, and if PPP holds, what happens to its real exchange rate?
A) It depreciates by 10%.
B) It appreciates by 10%.
C) It does not change.
D) It becomes negative.

Question

Quizplus · Accepted Answer

According to Purchasing Power Parity (PPP), the real exchange rate remains constant if inflation differences are offset by nominal exchange rate changes. Thus, if one country experiences 10% inflation and the other does not, the nominal exchange rate should adjust to maintain the real exchange rate.

If a Nation Experiences 10% Inflation and Its Trading Partner