Relative PPP

Definition

Relative Purchasing Power Parity (PPP) is an economic theory that suggests the rate of change in the prices of two countries' goods and services can predict changes in the exchange rate between their currencies over time. This concept emphasizes that if one country experiences higher inflation than another, its currency should depreciate in relation to the other country's currency to maintain purchasing power equilibrium.

5 Must Know Facts For Your Next Test

1. Relative PPP focuses on how inflation differentials between countries affect their exchange rates over time, rather than comparing absolute price levels.
2. If a country has a higher inflation rate compared to another, relative PPP predicts that its currency will depreciate against the other currency.
3. Relative PPP is often used as a long-term predictor of exchange rate movements, acknowledging that short-term fluctuations can be influenced by other factors like interest rates or political events.
4. The concept assumes that arbitrage opportunities exist, meaning investors will act on price differences until they are eliminated by market forces.
5. While relative PPP holds significant theoretical value, empirical evidence can be mixed due to various real-world complexities, such as market imperfections.

Review Questions

• How does relative PPP explain the relationship between inflation rates and exchange rates over time?
  • Relative PPP explains that if one country experiences higher inflation than another, its currency should depreciate relative to the other country's currency. This happens because higher inflation decreases purchasing power, leading to a change in demand for goods priced in that currency. Thus, the exchange rate adjusts to reflect these inflationary differences over time.
• Evaluate the implications of relative PPP for international investors when considering currency investments.
  • For international investors, relative PPP suggests that understanding inflation trends is crucial for making informed decisions about currency investments. If an investor anticipates that a country will experience higher inflation, they might decide to avoid investing in its currency as it is expected to lose value relative to others. Additionally, this understanding can help them strategize their portfolio by anticipating potential currency depreciation.
• Critically assess the limitations of relative PPP as a predictor of exchange rates in practical scenarios.
  • While relative PPP provides a foundational framework for understanding exchange rate movements in relation to inflation differentials, it faces limitations in practical application. Factors such as government interventions, market speculation, and sudden geopolitical events can distort predicted outcomes. Furthermore, deviations from purchasing power parity may persist for extended periods due to transaction costs and other frictions, making it difficult for investors and economists to rely solely on relative PPP for accurate forecasts.

Related terms

Absolute PPP: A theory that states that identical goods should have the same price when expressed in a common currency, assuming no transportation costs or trade barriers.

Inflation Rate:

The rate at which the general level of prices for goods and services rises, eroding purchasing power.

Exchange Rate: The value of one currency for the purpose of conversion to another, influencing international trade and investments.