ACCA Financial Management (F9) Certification Practice Exam

What does the variable 'hc' refer to in the Purchasing Power Parity Theory?

1. Inflation in the base country

2. Inflation in the country overseas

3. Base country market value

4. Base country interest rate

The correct answer is: Inflation in the country overseas

In the context of the Purchasing Power Parity (PPP) Theory, the variable 'hc' represents inflation in the overseas country. Purchasing Power Parity is based on the idea that in the absence of transportation costs and barriers to trade, identical goods should have the same price when expressed in a common currency. To evaluate how exchange rates will adjust based on differences in inflation rates between two countries, PPP considers that if one country has a higher rate of inflation compared to another, the value of its currency should depreciate relative to the other country to maintain parity in purchasing power. Therefore, in the equation relating exchange rates and inflation, the overseas inflation variable is crucial as it directly influences the expected movements in the exchange rate under PPP. The other options do not correctly define 'hc' within the PPP context. Inflation in the base country or interest rates are not captured by 'hc', and the base country market value does not pertain to the inflation rate necessary for PPP calculations. Hence, the focus on overseas inflation correctly identifies its significant role in understanding how currency values should adjust under PPP theory.