Which of the following statement related to the Purchasing Power Parity PPP theory is correct ...........

Economic and Social Issues Nature of Indian economy

Which of the following statement related to the (Purchasing Power Parity) PPP theory is correct?

This theory makes short-term predictions about exchange rates in a flexible exchange rate system.

It states that if one country has higher inflation than another, its exchange rate should be appreciating.

It states that differences in the domestic inflation and foreign inflation are a major cause of adjustment in exchange rates.

Both 1 and 2

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Explanation:

The Purchasing Power Parity (PPP) theory is used to make long-run predictions about exchange rates in a flexible exchange rate system. According to the theory, as long as there are no barriers to trade like tariffs (taxes on trade) and quotas (quantitative limits on imports), exchange rates should eventually adjust so that the same product costs the same whether measured in rupees in India, or dollars in the US, yen in Japan and so on, except for differences in transportation.

According to the PPP theory, differences in the domestic inflation and foreign inflation are a major cause of adjustment in exchange rates. If one country has higher inflation than another, its exchange rate should be depreciating.