What Is Relative Purchasing Power Parity?

Jim B.

Relative purchasing power parity is a concept which states that the inflation rates of individual nations have effects on the purchasing power of those countries. According to this theory, if one country has an inflation rate higher than that of another country, the country with the higher rate's currency should depreciate to the level of the other currency. Should it fail to do so, there is opportunity for arbitrage, which occurs when traders take advantages 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 should be absolutely reflected by the currency exchange rate between them.

Businesswoman talking on a mobile phone
Businesswoman talking on a mobile phone

Trade between countries is one of the most important aspects of the global economy. Economists closely study the price indexes of various countries in conjunction with the currency values of those nations how they are related to each other. Although there is no overarching currency to connect all of the various countries, the concept of purchasing power parity states that one item should cost essentially the same no matter 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 should be directly related to the exchange rate between those countries. If one country's prices are lower after exchange rates are considered, consumers would take advantage of those lower prices. This would eventually the drive prices in that country higher, restoring equilibrium to APPP.

APPP does not take into account that inflation rates can be different depending on the countries involved. This is where RPPP comes into play, since it factors these rates into the equation. For example, if the inflation rate is five percent higher in Country A than in Country B, the prices in Country A would be five percent higher once exchange rates were figured. It also means that Country A's currency must depreciate by five percent when compared to the currency of Country B, since inflation devalues 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 could throw RPPP measurements off the mark. In addition, any economy which restricts competition for goods would cause relative purchasing power parity to be inaccurate.

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