_________ theory states that the exchange rate between currencies of two countries should be equal to the ratio of the countries price levels.

The correct answer is B. PPP, which stands for Purchasing Power Parity. The theory of Purchasing Power Parity suggests that the exchange rate between the currencies of two countries should be equal to the ratio of their respective price levels.

It is a fundamental concept in international economics and finance used to understand how exchange rates are determined based on the relative price levels of different countries. Let’s delve into a detailed explanation of why PPP is the correct answer and why the other options are not correct:

Correct Answer (B. PPP):

Purchasing Power Parity (PPP) is a theory that links exchange rates and price levels. It posits that in the absence of transportation costs and trade barriers, identical goods should sell for the same price in two separate markets when expressed in a common currency.

This implies that exchange rates should adjust to ensure that a unit of one country’s currency can buy the same quantity of goods as a unit of another country’s currency.

The Purchasing Power Parity theory comes in two forms:

1. Absolute Purchasing Power Parity (Absolute PPP):

This form suggests that the exchange rate between two countries’ currencies should be equal to the ratio of their price levels. Mathematically, if P1 is the price level in one country, P2 is the price level in another country, and E is the exchange rate, then Absolute PPP can be represented as E = P1 / P2.

2. Relative Purchasing Power Parity (Relative PPP):

Relative PPP extends the concept to include changes in price levels over time. It posits that the change in exchange rates should be equal to the difference in the inflation rates of two countries.

Mathematically, if ΔE is the change in the exchange rate, ΔP1 is the change in price level in one country, and ΔP2 is the change in price level in another country, then Relative PPP can be represented as ΔE = ΔP1 – ΔP2.

This theory helps in understanding the long-term behavior of exchange rates and the factors that influence them. However, it’s important to note that PPP is a simplified model that assumes several ideal conditions, such as perfect competition and the absence of transaction costs, which may not hold in the real world. As a result, it is used as a guideline rather than an exact predictor of exchange rate movements.

Now, let’s explain why the other options are not correct:

A. IRP (Interest Rate Parity):

Interest Rate Parity (IRP) is a theory that relates exchange rates and interest rates. It suggests that the difference in interest rates between two countries should be equal to the expected change in the exchange rate over a specified period. While IRP is an important concept in international finance, it is distinct from PPP. IRP focuses on interest rates, whereas PPP focuses on price levels.

C. Fisher’s Theory (Fisher Effect):

Fisher’s Theory, also known as the Fisher Effect, pertains to the relationship between nominal interest rates, real interest rates, and inflation. It suggests that nominal interest rates in a country will adjust in response to changes in expected inflation. However, Fisher’s Theory deals with interest rates and inflation, not exchange rates and price levels, as in the case of PPP.

D. T-Bills (Treasury Bills):

T-Bills, or Treasury Bills, are short-term debt securities issued by the government. They are used to raise funds and manage government finances, but they are not a theory or concept related to exchange rates. T-Bills are part of the money market, where short-term debt securities are bought and sold. They do not directly relate to the exchange rate theories discussed in the question.

In conclusion, the correct answer is B. PPP (Purchasing Power Parity) because it is the theory that states that the exchange rate between currencies of two countries should be equal to the ratio of their price levels.

The other options, A (IRP), C (Fisher’s Theory), and D (T-Bills), are not related to this specific theory; they pertain to interest rates, inflation, and financial instruments, respectively, but they do not address the relationship between exchange rates and price levels as PPP does.