What is Purchasing Power Parity (PPP) and Interest Rate Parity (IRP)? Discuss the reasons for deviation of PPP relationship and IRP relationship.

Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) are two fundamental concepts in international financial management that help explain the relationship between exchange rates, inflation, and interest rates across countries. These theories provide a framework for understanding how currencies should behave in theory and why deviations from these theoretical relationships occur in practice.

Purchasing Power Parity (PPP)

Purchasing Power Parity is an economic theory that suggests that in the absence of transportation costs and other frictions, identical goods or services in different countries should have the same price when expressed in a common currency. In other words, the exchange rate between two currencies should adjust so that a basket of goods or services costs the same in both countries when priced in a common currency.

The idea behind PPP is based on the law of one price, which states that if two markets are in perfect competition and there are no transportation costs or tariffs, the price of a good should be the same in both markets when converted into a common currency. If a good is cheaper in one country than another, there should be an incentive for traders to exploit this price difference by buying in the cheaper country and selling in the more expensive one, thus driving the price difference toward parity.

PPP can be expressed mathematically as:

E1E2=P1P2\frac{E_{1}}{E_{2}} = \frac{P_{1}}{P_{2}}

Where:

• E1E_{1} and E2E_{2} are the exchange rates of two currencies,
• P1P_{1} and P2P_{2} are the price levels in two countries.

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