Which theory states that changes in the exchange rate of currencies reflects only changes in the price levels of two countries.

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justaguide | College Teacher | (Level 2) Distinguished Educator

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The "purchasing power parity"  also referred to as the "the law of one price," states that the exchange rate between currencies of two nations is determined by the price levels prevailing in the two countries.

According to the law of one price the cost of goods that can be shipped across the borders of two countries should cost the same in both the countries. As an illustration, take two countries A and B that use the currency Ca and Cb respectively. If free trade is allowed between the two, the price of commodities in both the countries in terms of both Ca as well as Cb should be the same. If the exchange rate between Ca and Cb is such that it is cheaper for a person in A to buy the same items from B, traders in A would start to buy from B, ship them across the border and sell them to customers in A for a profit. But to do this they would have to first use their currency Ca to first buy Cb that could then be used to buy the goods in B. This increase in demand for Cb would change the exchange rate between Ca and Cb such that the cost of the same group of items in both A as well as B would be the same if the exchange rate is taken into account.

The law of one price is the reason behind the depreciation of the currency of any nation against the currency of a nation that has a lower rate of inflation than the former in the log run.

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