Ppp Theory Of Exchange Rate

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Exchange rate is relative price of a currency and it determined by flow of currency through the foreign exchange rate market. The exchange rate can be divided into a nominal exchange rate and a real exchange rate. The nominal exchange rate is the rate at which the currencies of two countries can be exchanged, while the real exchange rate is the ratio of what a specified amount of money can buy in one country compared with what it can buy in another.The nominal exchange rate is the rate at which two different currencies are swapped. The real exchange rate explains how expensive commodities are in different countries and reflects the competitiveness of a country’s exports.
Exchange rate is influenced by a number of factors including, relative price levels, balances of payments, interest rates and risk. The relationship between these factors and how they determine exchange rate can be explained by different approaches. One of these theories is the purchasing power parity (PPP) theory.
The theory of PPP state that price levels in any two countries should be identical after converting prices into common currency (Pakko and Pollard, 2003). PPP theory is primarily derived from the law of one price which states that, in the presence of a competitive market structure and the absence of transportation
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The absolute PPP is based on a strict interpretation of the law of one price and the relative PPP is based on a weaker one. According to Pilbeam (2013:126), absolute version of PPP holds that if one takes a bundle of goods in one country and compare the price of that bundle with an identical bundle of goods sold in a foreign country, converted by the exchange rate into a common currency of measurement, then the prices will be equal. This means a rise in the price level relative to the foreign price level will lead to proportion depreciation of the home currency against the foreign

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