One Price Theory

One Price Theory

This is a theory that supports the law of one price. The theory says that the price of one product should be the same across countries. So, the exchange rates should adjust to reflect this 'one-price' scenario. Otherwise, international arbitrage could incur until exchange rates adjust and the law of one price holds.
For example, if Burger King Sandwich costs 2 euro in France, and the same sandwich 100 Thai baht in Thailand, then the exchange rate should be 50 baht per euro. If baht is depreciated in relative to euro (the exchange rate is more than 50 baht per euro), then Some French people will not buy any Sandwich from France. Rather, they will import Sandwich from Thailand (because Thai sandwich are cheaper) and resell in France to get immediate gains. Therefore, French will demand more Thai baht to purchase Sandwich from Thailand. More demand for Baht currency would result in appreciation of Thai baht... The exchange rates would then adjust until international arbitrage is not profitable. It is a notice that the PPP theory assumes no taxes, no transportation expenses, no transportation risks… PPP holds better for high- inflation countries.
It states that “theory that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. Interest rate parity plays an essential role in foreign exchange markets, connecting interest rates, spot exchange rates and foreign exchange rates.”
In fact, the fundamental aspect of Interest Rate Parity (IRP) is very similar to Purchasing Power Parity which applies the direct exchange rate to the value of a commodity in some countries in order to see what the price should be in dollars in a frictionless world. If the prices in the United States rise faster than those in other countries then the interest rate parity must not hold ( higher inflation) because of the reason given above, will mean the US interest rate has to rise to keep foreign investments following in US market as the prevailing interest parity is lost.
IRP holds better under rational expectations of agents, and PPP assumptions does not allow even temporary volatility/deviations from price level equilibriums (and also it explains only long-run but doesn't fits short-run).

If we look at exchange rate for its following as Nominal exchange rate of anther nation and the host nation, CPI, and PPI:The inclusion of the CPI and PPI in exchange rates are given on a quarterly basis and thus only change every quarter. The hardest hitting affects of exchange rate change is that of demand and supply of the currency in question, which leads to CPI and PPI changes, which is reflected in the next quarter. Regional inflation differentials lead to a competition between the real interest rate and wealth channels on the one hand and the real exchange rate channel on the other hand in the transmission of regional shocks. This may have implications for the length and vehemence of regional business cycles.Some studies suggest that Inflation persistence continues to be the most important driver of inflation differentials, though it no longer generates explosive oscillations. A forward-looking behavior of output tends to stabilize the model. The second formulation for the output gap equation is a mixed backward- and forward-looking specification, with parameters restricted to sum to unity. Here, inflation differentials become very sensitive to the degree of output persistence within the confidence range. However, because inflationary measures have a lag, due to reporting periods, where as exchange rates are constantly changing by the second, we can see how exchange rates are more stock because quite simply, we can see the change occurring instantly where as inflation differentials take time to computer and analyses.
Into the international financial system the short-term rate of interest is unlikely to be an efficient or even a particularly good predictor of inflation. It is argued that the rate of interest in these countries is much more likely to reflect foreign influences first and inflation expectation second and hence that the rate of interest may not efficiently embody all information relevant to the future inflation rate.