Chartered Financial Analyst (CFA) Practice Exam Level 2

Purchasing Power Parity (PPP) is a fundamental economic theory that posits that in the long run, exchange rates should adjust so that identical goods or baskets of goods have the same price when expressed in a common currency. This concept is grounded in the idea that in a frictionless market, arbitrage will lead to equal prices for the same goods across different countries. Therefore, if one country has a higher price level than another, its currency is expected to depreciate relative to the other currency to bring prices into alignment.

This means that fluctuations in exchange rates tend to reflect differences in inflation rates and price levels between countries. As a result, the long-term predictability of exchange rates can be linked to relative price levels determined by PPP. Consequently, if one country experiences higher inflation than another, its currency should weaken over time in order for the purchasing power of its currency to remain consistent with that of the foreign currency.

Understanding this principle is crucial for long-term currency forecasting and can guide investment strategies that involve currency exposure.