Compare and Contrast interest rate parity, purchasing power parity and international Fisher Effect.
Purchasing Power Parity theory
The theory of Purchasing Power Parity postulates that foreign exchange rates should be evaluated by the relative prices of a similar basket of goods between two nations. A possible change in the rate of inflation of a given country should be balanced by the opposite change of country’s exchange rate. If prices in the country are surging because of inflation, country’s exchange rate should decrease in order to return to parity.
The basket of goods and services includes a sample of all goods and services, which are covered by a country’s Gross Domestic Product. Consumer goods and services, services by the government, equipment goods and so on are all included in the basket. Among consumer goods and services are items such as food, drinks, clothing, footwear, tobacco, rents, medical goods and services, water and gas supply, fuel, transport services, recreational and cultural services, education services etc.
Interest Rate Parity theory
This theory assumes that if two currencies have different interest rates, this difference will lead to a discount or premium for the exchange rate in order to avoid arbitrage opportunities. We discuss the role of arbitrageurs in the market in our Forex Trading guide.
A simple example may be a situation, where interest rates in the United Kingdom are, say, 2%, while interest rates in Japan are, say, 1%. The sterling will need to depreciate 1% against the Japanese yen so that arbitrage opportunities can
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