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Q. Changes in exchange rates?
The law of one price proposed that identical goods selling in different countries should sell at the same price and that exchange rates relate these identical values. This directs on to purchasing power parity theory which suggests that changes in exchange rates over time must reflect relative changes in inflation between two countries. If purchasing power equality holds true the expected spot rate (S1) can be forecast from the current spot rate (S0) by multiplying by the ratio of expected inflation rates ((1 + if)/ (1 + iUK)) in the two counties being considered. In formula form S1 = S0 (1 + if)/ (1 + iUK).
This relationship has been found to embrace in the longer-term rather than the shorter-term and so tends to be used for forecasting exchange rates several years in the future rather than for periods of less than one year. For shorter periods forward rates are able to be calculated using interest rate parity theory which suggests that changes in exchange rates reflect differences between interest rates between countries.
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