The document discusses theories of Purchasing Power Parity (PPP) and Interest Rate Parity. It explains that PPP holds that identical baskets of goods should cost the same in different countries after accounting for exchange rates. It also discusses how PPP is measured using concepts like the Big Mac Index and OECD PPP Index. The document notes limitations of PPP theory and also provides an overview of Interest Rate Parity, stating that it asserts that interest rate differences between countries should equal the spread between spot and forward exchange rates.

1.  Purchasing Power
Parity
 Interest Rate Parity
.

2.  The Purchasing Power Parity (PPP) theory measures the
purchasing power of one currency against another after
taking into account their exchange rate.
 Developed by Gustav Cassel in 1918, the theory states that, in
ideally efficient markets, identical goods should have only one
price.
 Simply, what this means is that a bundle of goods should
ideally cost the same in Canada and the United States.
1. Purchasing Power Parity

3.  PPP’s Basket of Goods The basket of goods and services
priced for the PPP exercise is a sample of all goods and
services covered by GDP
> It includes consumer goods and service, government
services, equipment goods and construction projects.
> Includes food, beverages, tobacco, clothing, foot wears,
rents, water supply, gas, electricity etc.
.

4.  Big mac index One of the most famous examples of PPP is Big
Mac Index. an informal way of measuring the purchasing
power parity (PPP) between two currencies and provides a test
of the extent to which market exchange rates result in goods
costing the same in different countries.
 OECD Purchasing Power Parity Index A more formal index is
put out by the organization for Economic Cooperation and
Development. Under a joint OECD-Eurostat PPP program, the
OECD and Eurostat share the responsibility for calculating
PPP’s.
.

5.  The theory assumes that changes in price levels could bring
about changes in exchange rates not vice versa, that is,
changes in exchange rates cannot affect domestic price levels
of the countries concerned.
 The calculated new rate would represent the equilibrium rate
at purchasing power parity only if economic conditions have
remained unchanged
Limitations

6.  According to the theory, to calculate the new equilibrium rate
one must know the base rate i.e., the old equilibrium rate. But
it is difficult to ascertain the particular rate which actually
prevailed between the currencies as the equilibrium rate.
 According to the theory, to calculate the new equilibrium rate
one must know the base rate i.e., the old equilibrium rate. But
it is difficult to ascertain the particular rate which actually
prevailed between the currencies as the equilibrium rate.
.

7.  The Interest Rate Parity states that the interest rate
difference between two countries is equal to the percentage
difference between the forward exchange rate and the spot
exchange rate.
 It plays essential role in foreign exchange markets.
 The difference between the interest rates in any two
countries is the same as the difference between the forward
and the spot rates of their respective currencies.
 The return on a currency is the interest rate on that
currency plus the expected rate of appreciation over a given
period.
Interest rate parity