Explain the Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) relationship in detail.

The concepts of Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) play a crucial role in International Financial Management, influencing exchange rates, investment decisions, and economic policies. These theories help in understanding currency valuation, interest rate differentials, and the arbitrage mechanisms that drive global financial markets.

Purchasing Power Parity (PPP)

Purchasing Power Parity (PPP) is an economic theory that states that the exchange rate between two countries should adjust so that identical goods or services cost the same in both countries when measured in a common currency. This theory is based on the Law of One Price, which assumes that in the absence of transportation costs and trade barriers, identical goods should have the same price in different countries.

Types of PPP

1. Absolute PPP: It states that the exchange rate between two currencies is equal to the ratio ______ __________ ________ __________ _____.
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