International finance Essay Example | Topics and Well Written Essays - 500 words

International finance - Essay Example By actually knowing the exchange rate of the other currency (one year from the base year), banks and individuals earn an effective interest rate rather than the simple interest rate that would have been earned if the funds are left deposited in the bank. Using the theory of purchasing power parity, explain how inflation impacts exchange rates. Based on the theory of purchasing power parity, what can we infer about the difference in inflation between Ireland and the USA during the year your lottery winnings were invested? First, in order to explain how inflation impact exchange rates, it is necessary to define purchasing power parity. The Dictionary of Economics defines purchasing power parity as â€Å"a theory which states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent†. Since after one year, the rate of exchange became US$1 = Euro 1.30, there was a 4 per cent inflation in Ireland which caused a devaluation in their exchange rate. The inflation rate was computed as follows: (1.30 – 1.20)/1.20. While there was no mention of any change in exchange rate in the US, it can be inferred that there was no inflation increase. Therefore, the value of its currency remained the