Relative Purchasing Power Parity
Encyclopedia
Relative Purchasing Power Parity is an economic theory
which predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. It is a dynamic version of the absolute PPP theory.
The theory states that if the price P in country A of a basket of commodities and services is P A-dollars, then the price Q of the same basket in country B will be C×P A-dollars, where C is a constant which does not vary over time, or, equivalently, C×P×S B-dollars, where S is the (variable) number of B-dollars required to buy one A-dollar, i.e. the exchange rate.
If (1) and (2) denote two different dates, then it follows that
1/C = P(1)×S(1)/Q(1) = P(2)×S(2)/Q(2)
and hence
S(2)/S(1) = (Q(2)/Q(1))÷(P(2)/P(1))
or, in words, the factor representing the movement in market exchange rates is equal to the ratio of the inflation
factors (changes in price levels) of the two countries (as one would intuitively expect).
Absolute purchasing power parity occurs when C=1, and is a special case of the above.
According to this theory, the change in the exchange rate is determined by price level changes in both countries. For example, if prices in the United States
rise by 3% and prices in the European Union
rise by 1% the purchasing power of the EUR
should appreciate by approximately 2% compared to the purchasing power of the USD
(equivalently the USD
will depreciate by about 2%).
Note that it is incorrect to do the calculation by subtracting these percentages - one must use the above formula, giving 1.01/1.03 = .98058, i.e. a 1.942% depreciation of the USD
. With larger price rises, the difference between the incorrect and the correct formula becomes larger.
between two currencies will force their purchasing power
s to be equal. This theory is likely to hold well for commodities which are easily transportable between the two countries (such as gold, assuming this is freely transferable) but is likely to be false for other goods and services which cannot easily be transported, because the transportation costs will distort the parity.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
which predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. It is a dynamic version of the absolute PPP theory.
Explanation
Suppose that the currency of Country A is called the A$ (A-dollar) and the currency of country B is called the B$.The theory states that if the price P in country A of a basket of commodities and services is P A-dollars, then the price Q of the same basket in country B will be C×P A-dollars, where C is a constant which does not vary over time, or, equivalently, C×P×S B-dollars, where S is the (variable) number of B-dollars required to buy one A-dollar, i.e. the exchange rate.
If (1) and (2) denote two different dates, then it follows that
1/C = P(1)×S(1)/Q(1) = P(2)×S(2)/Q(2)
and hence
S(2)/S(1) = (Q(2)/Q(1))÷(P(2)/P(1))
or, in words, the factor representing the movement in market exchange rates is equal to the ratio of the inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
factors (changes in price levels) of the two countries (as one would intuitively expect).
Absolute purchasing power parity occurs when C=1, and is a special case of the above.
According to this theory, the change in the exchange rate is determined by price level changes in both countries. For example, if prices in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
rise by 3% and prices in the European Union
European Union
The European Union is an economic and political union of 27 independent member states which are located primarily in Europe. The EU traces its origins from the European Coal and Steel Community and the European Economic Community , formed by six countries in 1958...
rise by 1% the purchasing power of the EUR
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...
should appreciate by approximately 2% compared to the purchasing power of the USD
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....
(equivalently the USD
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....
will depreciate by about 2%).
Note that it is incorrect to do the calculation by subtracting these percentages - one must use the above formula, giving 1.01/1.03 = .98058, i.e. a 1.942% depreciation of the USD
United States dollar
The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....
. With larger price rises, the difference between the incorrect and the correct formula becomes larger.
Absolute Purchasing Power Parity
Commonly called absolute purchasing power parity, this theory assumes that equilibrium in the exchange rateExchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
between two currencies will force their purchasing power
Purchasing power
Purchasing power is the number of goods/services that can be purchased with a unit of currency. For example, if you had taken one dollar to a store in the 1950s, you would have been able to buy a greater number of items than you would today, indicating that you would have had a greater purchasing...
s to be equal. This theory is likely to hold well for commodities which are easily transportable between the two countries (such as gold, assuming this is freely transferable) but is likely to be false for other goods and services which cannot easily be transported, because the transportation costs will distort the parity.