ACCA Financial Management (F9) Certification Practice Exam

Which principle states that the exchange rate between two currencies will equalize when the purchasing power of the currencies is the same in both countries?

1. Interest rate parity

2. Four-way equivalence

3. Purchasing power parity

4. Fisher effect

The correct answer is: Purchasing power parity

The principle that states the exchange rate between two currencies will equalize when the purchasing power of the currencies is the same in both countries is known as Purchasing Power Parity (PPP). This concept posits that in the long run, exchange rates should adjust so that similar goods and services cost the same in different locations when measured in a common currency. PPP is essential in understanding how currency values adjust based on the relative price levels between two countries. For example, if a basket of goods costs significantly more in one country than in another, the currency of the more expensive country is expected to depreciate in value, or the more affordable country's currency is expected to appreciate until the price levels equalize. This principle relies on the assumptions of a competitive market and ignores factors such as transportation costs, tariffs, and other trade barriers which might affect actual currency values in the short term. In contrast, the other options represent different financial concepts: Interest Rate Parity relates to the relationship between interest rates and exchange rates; the Fisher Effect explains the relationship between nominal interest rates, real interest rates, and inflation; while the term Four-way Equivalence does not correspond to a widely recognized financial principle in this context. Thus, Purchasing Power Parity is the most appropriate choice