What do you understand by Purchasing Power Parity (PPP) and Interest R

Question

What do you understand by Purchasing Power Parity (PPP) and Interest Rate Parity? Explain the reasons for deviation of these parity conditions.

31 Mar 2022

Answer :

Word Count : 635

Purchasing Power Parity (PPP):

Purchasing Power Parity is a fundamental concept in international financial management that relates to the exchange rate between two currencies. The theory 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 other words, the exchange rate should reflect the relative purchasing power of the two currencies.

The formula for PPP is:

\[ S = P_1/P_2 \]

where:
- \(S\) is the exchange rate,
- \(P_1\) is the price level in one country, and
- \(P_2\) is the price level in another country.

If the actual exchange rate (\(S\)) deviates from the PPP-based exchange rate, it implies an opportunity for arbitrage, where traders _______ __________ ______ __________ ______ _____ ___ ___.
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