This 9 page paper compares the theory and the reality behind the theories of purchasing power parity and interest rate parity covered and uncovered behave when tested. The paper considers the theories and looks at them ion connection to the UK and Germany. The weaknesses of each model are also examined before a conclusion regarding the impact and accuracy are reached. The bibliography cites 12 sources.
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rates move and the patterns to their movements. To consider how PPP can be tested, along with uncovered interest rate parity we first have to examine the theory and how
it may be applied in practice as well as theory we can consider two countries such as the UK and Germany. This is
also sometimes referred to as the inflation theory of exchange rates, and has its basis in the sixteenth century Spanish Salamanca school added to with the work of Gerrard de
Malynes and later of Keynes, who attributed the model as we see it today to David Ricardo in theory and named by Gustav Cassel (Keynes, 1971).
This theory is based on the law of one price, or the no arbitrage argument (Keynes, 1971). In very simple terms this model looks to the
supply and demand for currency as it is flow theory. The idea is that currency will be demanded by a country where there is the need to pay for
goods that are imported, the more goods are imported the more of that countrys currency will be demanded. Where there is a demand that is growing and that exceed supply
the price would increase. There is little that can be disagreed with here. This then goes further and looks at the role of interest rates and inflation.
The result of this is the theory that goods in different countries will be of the same price in terms of comparison. This can
be seen with an example. The absolute Purchasing Power Parity (or PPP) spot exchange rate is determined by relative prices for a collection of similar goods in the different