A theory that compares currencies based on what they can buy domestically.

• A. Exchange Rate Theory
• B. Purchasing Power Parity (PPP)
• C. Currency Appreciation
• D. Inflation

Answer: (B)

Purchasing Power Parity explains how currencies are valued by what they can buy in their domestic markets. It holds that exchange rates adjust so a similar basket of goods costs the same amount when priced in a common currency. If one country has a higher price level than another, its currency should depreciate relative to the other until the purchasing power lines up. You can think of absolute PPP as comparing the exact price of a fixed basket across countries, and relative PPP as focusing on how inflation differences between countries drive changes in exchange rates over time. This directly ties the value of a currency to domestic purchasing power, which is why it’s the best fit. Inflation describes rising prices generally, currency appreciation is a movement in value rather than a theory, and a broad exchange rate theory doesn’t specify the link to purchasing power.