In the long run, the value of a country’s currency is tied to the price of goods and services in that country.

a. The law of one price states that two identical goods should sell for the same price, regardless of location.

b. The law of one price fails because of transportation costs, differences in taxation and technical specifications, and the fact that some goods cannot be moved.

c. The theory of purchasing power parity applies the law of one price to international transactions; it states that the real exchange rate always equals one.

d. Purchasing power parity implies that countries with higher inflation than other countries will experience exchange rate depreciation.

e. Over decades, exchange rate changes are approximately equal to differences in inflation, implying that purchasing power parity holds.