Law of One Price: Relation Between Exchange Rate and Inflation

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Inflation rates and exchange rates: The relationship between inflation rates and exchange rates is governed by the purchasing power parity theory. According to purchasing power parity theory any differences in the rate of inflation will be offset by the change in exchange rate. For example, if the prices are rising in US at the rate of 2% per annum while in India the prices are rising at the rate of 6% per annum. If the current exchange rate is Rupee 45 per US dollar, then the number of Indian Rupees one can buy by selling one US dollar must increase to ...