Question

What tends to be true for a company when a change in exchange rate is exactly offset by the inflation differential?

Group of answer choices

The company is likely to enter a new export market

The company's competitive position is not affected

The company will resort to exchange-rate pass through

The company will establish a manufacturing plant in a low-cost foreign country

Answer 1

The correct answer is:

Company will resort to exchange-rate pass through.

Here the concept of Purchasing Power Parity (PPP) theory applies.

This theory states that exhange rate movement offsets any inflation differential between countries.

When inflation is high in a particular country, demand of the product of that country in the foreign market gets reduced, and the demand for foreign goods in the domestic market gets increased. Thus weakening the home currency of that particular country. This tendency should continue for that time periods when the demand for foreign goods in domestic market is no more attractive in comparison to that of home country's product. This will equalize the market, and which in turn will offset the inflation differential through exchange rate pass through.