Relative purchasing power parity states that a country’s inflation rate affects its purchasing power, and if a country has a higher inflation rate than another, its currency must depreciate to the level of the other currency. This theory is related to absolute purchasing power parity, which states that price differences between countries must be reflected by the exchange rate between them. However, RPPP takes inflation rates into account. Barriers to trade and restricted competition can affect RPPP measurements.
Relative purchasing power parity is a concept that states that each country’s inflation rates affect those countries’ purchasing power. According to this theory, if a country has a higher inflation rate than another country, the country with the higher rate currency must depreciate to the level of the other currency. Failure to do so will create an opportunity for arbitrage, which occurs when traders take advantage of price discrepancies. The concept of relative purchasing power parity, or RPPP, is related to the similar idea of absolute purchasing power parity, which states that price differences between countries must absolutely be reflected by the exchange rate between them.
Trade between countries is one of the most important aspects of the global economy. Economists closely study the price indices of various countries, together with the monetary values of these nations, as they relate to each other. While there is no overarching currency to connect all countries, the concept of purchasing power parity states that an item should cost essentially the same regardless of the country in which it is sold. Relative purchasing power parity takes inflation rates into account when studying this theory.
To understand relative purchasing power parity, it is crucial to understand its corollary, absolute purchasing power parity or APPP. APPP states that any difference in the prices of an item between countries must be directly related to the exchange rate between those countries. If a country’s prices are lower after accounting for exchange rates, consumers will take advantage of those lower prices. This would eventually raise prices in that country, restoring balance to the APPP.
APPP does not take into account that inflation rates can be different depending on the countries involved. This is where the RPPP comes into play, as it brings these rates into the equation. For example, if the inflation rate is five percent higher in country A than in country B, prices in country A would be five percent higher once exchange rates are calculated. This also means that country A’s currency must depreciate by five percent when compared to country B’s currency, as inflation devalues the currency.
While relative purchasing power parity makes sense in principle, there are circumstances that can affect the reality of pricing situations. Any barriers to trade between two specific countries can undermine RPPP measurements. Furthermore, any economy that restricts competition for goods would make relative purchasing power parity fuzzy.
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