Interest Parity vs Purchasing Power Parity

The Theory of Interest Parity and the Theory of Purchasing Power Parity provide different perspectives on the relationship between exchange rates and interest rates.

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LIDERBOT

2/4/20242 min read

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The Theory of Interest Parity

The Theory of Interest Parity suggests that the difference in interest rates between two countries determines the exchange rate between their currencies. According to this theory, if the interest rate in one country is higher than in another, investors will be attracted to invest in that country's currency. This increased demand for the currency will cause its value to appreciate, leading to a decrease in the exchange rate.

Interest parity can be further divided into two sub-theories: covered interest parity and uncovered interest parity.

Covered Interest Parity

Covered Interest Parity states that the forward exchange rate should equalize the interest rate differential between two countries. In other words, if the interest rate in one country is higher than in another, the forward exchange rate should reflect this difference. This theory assumes the absence of any arbitrage opportunities and assumes that there are no restrictions on capital flows.

Uncovered Interest Parity

Uncovered Interest Parity suggests that the expected change in the exchange rate should offset the interest rate differential between two countries. In other words, if the interest rate in one country is higher than in another, the expected depreciation of the currency should offset the interest rate advantage. This theory takes into account the expectations of market participants and assumes that there are no restrictions on capital flows.

The Theory of Purchasing Power Parity

The Theory of Purchasing Power Parity (PPP) states that the exchange rate between two currencies should equalize the prices of a basket of goods in both countries. According to this theory, if the price level in one country is higher than in another, the currency of the country with the higher price level will depreciate to restore equilibrium.

Purchasing Power Parity can be further divided into two sub-theories: absolute purchasing power parity and relative purchasing power parity.

Absolute Purchasing Power Parity

Absolute Purchasing Power Parity suggests that the exchange rate between two currencies should equalize the prices of identical goods in both countries. In other words, the exchange rate should reflect the relative purchasing power of each currency. This theory assumes the absence of any trade barriers and transportation costs.

Relative Purchasing Power Parity

Relative Purchasing Power Parity states that the change in the exchange rate should reflect the difference in the inflation rates between two countries. If the inflation rate in one country is higher than in another, the currency of the country with higher inflation will depreciate to compensate for the difference. This theory takes into account the impact of inflation on the purchasing power of a currency.

Differences between the Theories

While both the Theory of Interest Parity and the Theory of Purchasing Power Parity attempt to explain the relationship between exchange rates and interest rates, they differ in their underlying assumptions and implications.

One key difference is that the Theory of Interest Parity focuses on the relationship between interest rates and exchange rates, while the Theory of Purchasing Power Parity focuses on the relationship between price levels and exchange rates.

Another difference is that the Theory of Interest Parity assumes that capital flows are unrestricted and there are no arbitrage opportunities, while the Theory of Purchasing Power Parity assumes the absence of trade barriers and transportation costs.

Furthermore, the Theory of Interest Parity takes into account the expectations of market participants, while the Theory of Purchasing Power Parity focuses on the relative purchasing power and inflation rates of currencies.

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