Explain purchase power parity and interest rate parity as they relate to market price.

Explain purchase power parity and interest rate parity as they relate to market price.
i. The theory of Purchasing Power Parity (PPP) states that the exchange rate between two countries is
related to the ratio of the country’s price level. The price level here is calculated using a basket of goods
and services calculated in local currency of both countries. Formally, PPP is expressed as –
, where
is amount of US Dollars that a Euro can purchase; it is essentially the exchange rate in foreign
market.
is the US price level measured in Dollars
is the Euro region’s price level measured in Euro
One of the key implications of the Purchasing Power Parity is that countries price levels are same when
measured in same currency. Also, country with high level of inflation is likely to witness a depreciation of
its currency in the foreign exchange market. Note that is also known as Absolute PPP.
Another derived form of PPP is called Relative PPP which looks at the percentage change in above
variables over two periods. Formally, relative PPP is expressed as –
(
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