What do you understand by Purchasing Power Parity and Interest Rate Pa

Question

What do you understand by Purchasing Power Parity and Interest Rate Parity? Discuss the reasons for their deviations.

29 Feb 2024

Answer :

Word Count : 558

Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) are fundamental concepts in International Financial Management, providing insights into the relationship between exchange rates, inflation, and interest rates. Let's delve into each concept and explore the reasons for deviations.

1. Purchasing Power Parity (PPP):

Purchasing Power Parity is a theory that suggests that in the long run, exchange rates between two currencies should equalize the prices of an identical basket of goods and services in both countries. In simpler terms, it posits that the exchange rate between two currencies should reflect their relative purchasing power.

The formula for PPP is expressed as:

\[ S = P_1 / P_2 \]

Where:
- \( S \) is the exchange rate,
- \( P_1 \) is the price level in one country,
- \( P_2 \) is the price __________ ____ ___ ____ ___ _______ ___ ____ _______.
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