What do you understand by Purchasing Power Parity (PPP) and Interest rate Parity (IRP). Discuss the reasons for their deviation.

Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) are two fundamental concepts in the field of International Financial Management. They provide valuable insights into the relationships between exchange rates, inflation rates, and interest rates in a global economic context. In this extensive answer, I will explain what PPP and IRP are, their theoretical foundations, and the reasons for their deviation in real-world scenarios.

Purchasing Power Parity (PPP):

PPP is an economic theory that suggests that exchange rates between two countries' currencies should equalize the purchasing power of the two currencies for a given basket of goods. In other words, if PPP holds, a unit of currency in one country should have the same real value (purchasing power) as a unit of currency in another country. PPP is typically expressed as:

\[S = P_1 / P_2\]

Where:
- \(S\) represents the exchange rate between two currencies.
- \(P_1\) is the price level in one country.
- \(P_2\) is the price level in another country.

There are two main forms of PPP: Absolute PPP and Relative PPP.

1. Absolute PPP: This form of PPP suggests that the exchange rate should equal the ratio of the price levels in two countries. It assumes that the same basket of goods should cost the same in two different countries when measured in a common currency. However, in the real world, this form of PPP often does not hold due to various factors, such as differences in transportation costs, trade barriers, and taxes.

2. Relative PPP: Relative PPP, also known as the law of one price, posits that changes in exchange rates should offset differences in inflation rates between two countries. In other words, if inflation is higher in one country compared to another, its currency should ________ _________ _______ ________ _____ _______ ___ _________ _____ _________ _________ _________.
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