What does the theory of purchasing power parity suggest about exchange rates?

The theory of purchasing power parity (PPP) posits that in the long run, exchange rates between currencies will adjust to reflect changes in price levels between two countries. Essentially, it argues that the currency of a country should be able to purchase the same amount of goods and services in another country when adjusted for exchange rates. If one country experiences higher inflation than another, its currency should depreciate to maintain the purchasing power parity. This concept implies that differences in inflation rates over time will lead to corresponding adjustments in exchange rates, ensuring that the purchasing power remains equivalent across currencies.

The theory is rooted in the idea that arbitrage opportunities will arise if exchange rates do not adjust according to price levels. When there is a discrepancy between the actual exchange rate and the rate suggested by PPP, market participants will exploit this difference, leading to eventual corrections in the exchange rates. This aligns with the long-term view of exchange rate behaviors as guided by relative price levels rather than short-term fluctuations influenced by market speculation or movement of capital, which might explain the confusion with concepts related to current account balances and randomness in currency movements.