Parity

[abhishreshthaa]

Purchasing Power Parity Theory

• In theory, a good should cost the same in all countries (Law of One Price)
  
  
• As a result, exchange rates should end up making prices equal across countries
  
  
• By this theory, if two countries have different inflation rates, exchange rates will move in the opposite direction to keep prices the same

Interest Rate Parity

According to this theory,

• the cost of money when adjusted for the cost of covering foreign exchange risk, is the same across different currencies

This theory assumes,

• total absence of transaction costs, taxes, and capital controls, providing the investors and traders with an atmosphere of free trade

a
Law of One Price

• Identical goods should be sold for the same price in two different markets when there are no transportation costs, no transaction costs, no tariffs and no differential taxes applied in either market.

E.g. Big Mac