Relative Purchasing Power Parity (RPPP) is an expansion of the traditional purchasing power parity (PPP) theory to include changes in inflation over time. Purchasing power is the power of money expressed by the number of goods or services that one unit can buy, and which can be reduced by inflation. RPPP suggests that countries with higher rates of inflation will have a devalued currency.
- Relative purchasing power parity (RPPP) is an economic theory that states that exchange rates and inflation rates (price levels) in two countries should equal out over time.
- Relative PPP is an extension of absolute PPP in that it is a dynamic (as opposed to static) version of PPP.
- While PPP is useful in understanding macroeconomics in theory, in practice RPPP does not seem to hold true over short time horizons.
Understanding Relative Purchasing Power Parity (RPPP)
According to relative purchasing power parity (RPPP), the difference between the two countries’ rates of inflation and the cost of commodities will drive changes in the exchange rate between the two countries. RPPP expands on the idea of purchasing power parity and complements the theory of absolute purchasing power parity (APPP). The APPP concept declares that the exchange rate between the two nations will be equal to the ratio of the price levels for those two countries.
The relative version of PPP is calculated with the following formula:
S=P2P1where:S= Exchange rate of currency 1 to currency 2P1= Cost of good X in currency 1
Purchasing Power Parity in Theory
Purchasing power parity (PPP) is the idea that goods in one country will cost the same in another country, once their exchange rate is applied. According to this theory, two currencies are at par when a market basket of goods is valued the same in both countries. The comparison of prices of identical items in different countries will determine the PPP rate. However, an exact comparison is difficult due to differences in product quality, consumer attitudes, and economic conditions in each nation. Also, purchasing power parity is a theoretical concept which may not be true in the real world, especially in the short run.
Empirical evidence has shown that for many goods and baskets of goods, PPP is not observed in the short term, and there is uncertainty over whether it applies in the long term.
Dynamics of Relative PPP
RPPP is essentially a dynamic form of PPP, as it relates the change in two countries’ inflation rates to the change in their exchange rate. The theory holds that inflation will reduce the real purchasing power of a nation's currency. Thus if a country has an annual inflation rate of 10%, that country's currency will be able to purchase 10% less real goods at the end of one year.
RPPP also complements the theory of absolute purchasing power parity (APPP), which maintains that the exchange rate between two countries will be identical to the ratio of the price levels for those two countries. This concept comes from a basic idea known as the law of one price. This theory states that the real cost of a good must be the same across all countries after the consideration of the exchange rate.
Example of Relative Purchasing Power Parity
Suppose that over the next year, inflation causes average prices for goods in the U.S. to increase by 3%. In the same period, prices for products in Mexico increased by 6%. We can say that Mexico has had higher inflation than the U.S. since prices there have risen faster by three points.
According to the concept of relative purchase power parity, that three-point difference will drive a three-point change in the exchange rate between the U.S. and Mexico. So we can expect the Mexican peso to depreciate at the rate of 3% per year, or that the U.S. dollar should appreciate at the rate of 3% per year.