Under purchasing power parity, the future spot exchange rate is a function of the initial spot rate in equilibrium and. A. the forward discount or premium. B. the income differential. C. none of these D. the inflation differential.

The correct answer is D. the inflation differential.

Explanation:

It is the difference in the inflation rates between two geographical spaces, for example between Spain and Sweden within the EU, or Extremadura and Asturias in Spain.

If inflation occurs in the same integrated economic space, in the long term it causes loss of competitiveness, since the prices of goods and services in one area are more expensive than in another.

D) the inflation differential.

Explanation:

The inflation differential is simply the different inflation rates between two different countries. Usually an increase in the foreign exchange price of a currency (the currency depreciates) will lead to higher domestic inflation, since one of the reasons why the currency might have depreciated on the first place was a high inflation rate.  

When the foreign exchange rate increases, domestic goods become cheaper while imported goods get more expensive, which actually increases the purchasing power of foreign currencies. In this case, the purchasing power parity of the dollar (the base unit) increases against the domestic currency.

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