Question

QUESTION 1 According to the theory of purchasing power parity, the foreign exchange market will:

A.result in an increase in the supply of dollars whenever Australia's inflation rate is lower than the inflation rates in other countries.

B.result in a decrease in the demand of dollars whenever Australia's inflation rate is lower than the inflation rates in other countries.

C.undervalue the Australian dollar if inflation in Australia is higher than the inflation rates in other countries.

D.no longer demand Australian dollars if the inflation rate in Australia is higher than the inflation rates in other countries.

E.adjust the value of currencies to reflect differing inflation rates between countries.

Answer 1

Here, option a is incorrect because supply of dollars will fall if Australia's inflation rate is lower than the inflation rate of other countries. Again, option b is incorrect because demand for dollars must increase if Australia's inflation rate is lower than the inflation rate of other countries. If Australia's inflation rate is higher than that of other countries, Australian dollar depreciates or devalues. Hence, option c is correct. If Australia's inflation rate is higher than that of other countries, demand for Australian dollar falls. Thus, option d is incorrect. The foreign exchange market adjust the value of currencies to reflect differing exchange rates between countries. Thus, option e is incorrect. Only correct option is c.