Relative PPP

Definition

Relative Purchasing Power Parity (PPP) is an economic theory that suggests that the exchange rate between two currencies will adjust to reflect changes in price levels between the two countries. This theory implies that if a country experiences higher inflation compared to another, its currency should depreciate relative to the other currency, maintaining equilibrium in purchasing power across nations.

5 Must Know Facts For Your Next Test

1. Relative PPP focuses on changes in exchange rates as a function of inflation differentials between two countries over time.
2. This theory assumes that arbitrage opportunities will eventually lead to price adjustments in the currencies involved.
3. While it is a useful framework, relative PPP does not account for factors such as political instability or market imperfections that can affect currency values.
4. Empirical studies often find mixed results regarding the accuracy of relative PPP predictions, especially in the short term.
5. Relative PPP is often considered more practical than absolute PPP since it acknowledges that prices may not be equal due to various market frictions.

Review Questions

• How does Relative PPP explain the relationship between inflation rates and exchange rates?
  • Relative PPP explains that when one country experiences a higher inflation rate than another, its currency is expected to depreciate relative to the other currency. This adjustment occurs because higher inflation reduces the purchasing power of that country's currency, requiring more units of it to purchase the same goods and services as before. Over time, this leads to a change in the exchange rate that reflects the inflation differential, ensuring that purchasing power remains equivalent between countries.
• Evaluate the limitations of using Relative PPP as a predictive tool for exchange rate movements.
  • While Relative PPP provides a theoretical framework for understanding exchange rate adjustments based on inflation differentials, it has significant limitations. For instance, it does not account for short-term volatility caused by speculative trading or geopolitical events that can impact currency values. Additionally, factors like government intervention and differences in demand for currencies can create deviations from what Relative PPP would predict. Thus, while it may serve as a long-term guide, its effectiveness for short-term forecasting is often questioned.
• Synthesize how Relative PPP interacts with other theories of exchange rate determination and its implications for global trade.
  • Relative PPP interacts with other theories like absolute PPP and interest rate parity by providing insight into how price level changes impact currency values over time. Understanding these interactions is crucial for policymakers and businesses engaged in global trade. For example, if relative PPP holds true, exporters might adjust their pricing strategies based on anticipated currency fluctuations due to differing inflation rates. This can help companies maintain competitiveness in foreign markets and make informed decisions about pricing, sourcing, and hedging strategies in response to expected changes in exchange rates.

Related terms

Absolute PPP: A theory that states that in the long run, identical goods should have the same price in different countries when expressed in a common currency, ignoring transportation costs and tariffs.

Inflation Rate:

The percentage increase in the price level of goods and services in an economy over a specific period, often used to measure changes in purchasing power.

Exchange Rate:

The value of one currency for the purpose of conversion to another, which can fluctuate based on various economic factors, including relative PPP.