Consider the following quotation from the 1984 Economic
Report of the President: In the long run, the exchange rate tends to follow the differential trend in the domestic and foreign price level.
If one country's price level gets too far out of line with prices in other countries, there will eventually be a fall in demand for its goods, which will lead to a real depreciation of its currency.
Explain how the first sentence relates to the PPP theory of exchange rates. Explain the reasoning behind the PPP theory. In addition, using a supply and- demand diagram like that of Figure 27-3, explain the sequence of events, described in the second sentence of the quotation, whereby a country whose price level is relatively high will find that its exchange rate depreciates.