Introduction to Relative Purchasing Power Parity (RPPP)

Understanding Relative Purchasing Power Parity (RPPP)

The relative version of PPP is calculated with the following formula:

S = P 1 P 2 where: S =  Exchange rate of currency  1  to currency  2 P 1 =  Cost of good  X  in currency  1 \begin{aligned} &S=\frac{P_1}{P_2}\\ &\textbf{where:}\\ &S=\text{ Exchange rate of currency }1\text{ to currency }2\\ &P_1=\text{ Cost of good }X\text{ in currency }1\\ &P_2=\text{ Cost of good }X\text{ in currency }2 \end{aligned} 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.