Question

Cited sources such as the economist, WSJ, NYT.....

Differentiate between purchasing power parity and interest rate parity.

Support statement with sources.

Answer 1

Purchasing power parity (PPP) is an economic theory that compares the currencies of distinct nations by means of a "goods basket" strategy. According to this concept, if a basket of goods (taking into account the exchange rate) is priced the same in both countries, two currencies are in equilibrium or equal.

Interest rate parity is a theory where the interest rate differential is equal to the difference between the forward exchange rate and the spot exchange rate.

1. The PPP is based on spot prices, while both forward and spot interest rates are based on the IRP.

2. The PPP is used to calculate any economy's GDP in a broader term, whereas the IRP is directly concerned with that currency's PPP.

It focuses on why the forward rate differs from the spot rate and the degrees of difference that should exist. This relates to the specific time point.

-Key variables: forward rate premium-Base: interest rate differential-Summary: forward rate of one currency contains a premium (or discount) determined by the interest rate differential between the two countries. As a result, arbitrage of covered interest will provide a return that is no higher than a domestic return.

It focuses on how the spot rate of a currency will change over time. The theory suggests that, according to inflation differentials, the spot rate will change.

-Key variables: percent change in the spot exchange rate-Basis: differential inflation rate -Summary: the spot rate of one currency in relation to another will change in response to the inflation rate differential between two countries. Consequently, when buying goods in their own country, consumer purchasing power will be similar to their purchasing power when importing goods from abroad.