What does the Purchasing Power Parity (PPP) Theory primarily address?

The Purchasing Power Parity (PPP) Theory primarily focuses on the relationship between two countries' inflation rates and exchange rates. It posits that in the long run, exchange rates between two currencies will adjust so that identical goods in different countries have the same price when expressed in a common currency. This theory suggests that if one country experiences a higher inflation rate compared to another, its currency should depreciate relative to the other country's currency to maintain equilibrium in purchasing power.

This principle is rooted in the idea that exchange rates should reflect the relative purchasing power of the two currencies given the inflation rates. Thus, understanding how inflation rates in different countries impact exchange rates is essential in analyzing currency valuation and international trade dynamics.