What Is Relative Purchasing Power Parity?
Relative purchasing power parity (relative PPP) is a theory in International Finance that suggests the differential in inflation rates between two countries determines the change in their exchange rate over time. Unlike its absolute counterpart, relative PPP does not contend that identical goods should cost the same in different countries at a given moment. Instead, it posits that the rate of change in prices for a basket of goods in one country, relative to another, will be offset by an equivalent adjustment in the nominal exchange rate. This concept is crucial for understanding long-term currency movements and their relationship with price levels.
History and Origin
The foundational concept of purchasing power parity, from which relative purchasing power parity derives, has roots tracing back to the 16th century. However, it was Swedish economist Gustav Cassel who prominently developed and popularized the theory in 1918. Cassel's work, particularly during and after World War I, aimed to explain exchange rate determination in a period of floating currencies following the breakdown of the gold standard. His formulation of relative PPP suggested that shifts in price levels, driven by differing rates of inflation across countries, would be the primary drivers of changes in their exchange rates. This dynamic view provided a more flexible framework for analyzing currency valuation compared to static approaches.
Key Takeaways
- Relative purchasing power parity (relative PPP) predicts that changes in exchange rates between two currencies are determined by the difference in their national inflation rates.
- It is a dynamic theory, focusing on the rate of change rather than static price levels.
- Relative PPP implies that countries with higher inflation rates will experience a depreciation of their currency relative to countries with lower inflation rates.
- The theory is often considered more applicable in the long run, as short-term exchange rates are influenced by numerous other factors.
- It serves as a theoretical benchmark for understanding long-term trends in currency valuation.
Formula and Calculation
The formula for relative purchasing power parity describes the relationship between changes in exchange rates and inflation differentials. It can be expressed as:
Where:
- (E_t) = The spot nominal exchange rate at time (t) (expressed as units of foreign currency per unit of home currency)
- (E_{t-1}) = The spot nominal exchange rate at time (t-1) (the base period)
- (\pi_H) = The inflation rate in the home country
- (\pi_F) = The inflation rate in the foreign country
This formula indicates that the percentage change in the exchange rate equals the difference between the home country's inflation rate and the foreign country's inflation rate.
Interpreting Relative Purchasing Power Parity
Interpreting relative purchasing power parity involves understanding how differences in domestic and foreign inflation rates are expected to influence the nominal exchange rate over time. If a country experiences a higher rate of inflation compared to its trading partners, relative PPP suggests that its currency should depreciate to maintain the relative purchasing power of its goods internationally. Conversely, a country with lower inflation would see its currency appreciate. This adjustment aims to preserve the relative competitiveness of a nation's goods in international trade. While deviations from relative PPP can occur in the short term due to market arbitrage, the theory posits that these deviations tend to correct themselves over the long run, leading to a form of economic equilibrium.
Hypothetical Example
Consider a hypothetical scenario involving the United States and Canada. Assume that at the beginning of a year, the exchange rate is 1.30 Canadian Dollars (CAD) per 1 U.S. Dollar (USD). Over the year, the United States experiences an inflation rate of 3%, while Canada experiences an inflation rate of 1%.
Using the relative purchasing power parity formula:
Percentage change in exchange rate = (\pi_{US} - \pi_{Canada})
Percentage change in exchange rate = (0.03 - 0.01 = 0.02) or 2%
According to relative PPP, the USD is expected to appreciate by 2% against the CAD.
New exchange rate ((E_t)) = (E_{t-1} \times (1 + \text{Percentage change}))
New exchange rate = (1.30 \text{ CAD/USD} \times (1 + 0.02) = 1.30 \times 1.02 = 1.326 \text{ CAD/USD})
This means that if relative PPP holds, the exchange rate would shift from 1.30 CAD per USD to approximately 1.326 CAD per USD, reflecting the higher inflation in the U.S. and maintaining the relative international purchasing power. This adjustment ensures that the equivalent quantity of a basket of goods in both countries retains a similar real cost when converted at the new exchange rate.
Practical Applications
Relative purchasing power parity serves as a fundamental concept in several areas of finance and economics. It is often used as a long-term forecast for exchange rates, especially by macroeconomists and policymakers analyzing the stability of global financial systems. For instance, the International Monetary Fund's use of PPP for comparing countries' Gross Domestic Product (GDP) and other economic metrics implicitly acknowledges the principle of adjusting for price level differences.
Central banks may consider relative inflation trends when formulating monetary policy, anticipating how price differentials might affect their currency's value and, consequently, their nation's balance of payments. While not a perfect short-term predictor, relative PPP provides a baseline for assessing whether a currency is fundamentally overvalued or undervalued based on sustained inflation gaps. Researchers at institutions like the Bank for International Settlements compile data on real effective exchange rates, which incorporate relative price changes to gauge international competitiveness.
Limitations and Criticisms
While relative purchasing power parity offers a compelling theoretical framework for understanding exchange rate movements, it faces several significant limitations and criticisms in practice. One major issue is that relative PPP often fails to hold true in the short to medium term. Exchange rates are far more volatile than inflation rates and are influenced by numerous factors beyond just price levels, such as interest rate differentials, capital flows, productivity changes, and speculative trading.
Furthermore, the theory assumes that goods are freely tradable without significant barriers or costs. In reality, international trade is impacted by transportation costs, tariffs, non-tariff barriers, and differences in the quality or composition of the basket of goods consumed in different countries. Non-tradable goods and services (e.g., haircuts, real estate) also pose a challenge, as their prices are not directly exposed to international arbitrage and can differ significantly across borders, affecting overall price levels without corresponding exchange rate adjustments.
Despite its theoretical appeal, empirical evidence regarding the consistency of relative PPP, particularly outside of very long time horizons, is mixed. The Federal Reserve Bank of St. Louis notes that while some economists believe PPP may hold in the long run, deviations are common, influenced by local tastes and income levels. This suggests that while the concept provides a useful benchmark, its real-world predictive power is often limited by market frictions and structural differences between economies.
Relative Purchasing Power Parity vs. Absolute Purchasing Power Parity
The distinction between relative purchasing power parity and absolute purchasing power parity lies in their focus. Absolute purchasing power parity (absolute PPP) is a more stringent theory, positing that an identical basket of goods should cost the same in two different countries when expressed in a common currency, at any given point in time. This is based on the " law of one price" applied broadly across economies. Absolute PPP implies that the nominal exchange rate between two currencies should directly reflect the ratio of their respective aggregate price levels.
In contrast, relative purchasing power parity is a dynamic extension. It acknowledges that absolute price equality may not hold due to factors like transportation costs, trade barriers, or differing consumption patterns. Instead, relative PPP focuses on the change in exchange rates over time, asserting that it should correspond to the difference in inflation rates between two countries. Essentially, if prices in Country A rise by 5% and in Country B by 2%, relative PPP predicts that Country A's currency will depreciate by approximately 3% against Country B's, thus maintaining the relative purchasing power of their currencies over time. The confusion often arises because both theories relate price levels and exchange rates, but one emphasizes static equality while the other emphasizes dynamic adjustment.
FAQs
What does "relative" mean in relative purchasing power parity?
The "relative" in relative purchasing power parity refers to the change in the exchange rate being proportional to the difference in inflation rates between two countries, rather than comparing absolute price levels at a single point in time. It focuses on how currencies adjust to relative changes in purchasing power.
Is relative purchasing power parity a short-term or long-term theory?
Relative purchasing power parity is generally considered a long-term theory. In the short term, many other factors, such as interest rates, speculative activity, and government policies, can cause significant deviations from the predicted exchange rate. Over longer periods, however, the influence of differing inflation rates tends to exert a stronger pull on exchange rate movements.
How does relative purchasing power parity relate to the real exchange rate?
Relative purchasing power parity is closely linked to the concept of the real exchange rate. If relative PPP holds, it implies that the real exchange rate, which measures the relative price of goods and services between countries after adjusting for nominal exchange rates and price levels, should remain relatively stable or revert to a long-run mean. Significant and persistent deviations from relative PPP suggest a change in the equilibrium real exchange rate.
What factors can cause deviations from relative PPP?
Several factors can cause deviations from relative purchasing power parity, including transportation costs, trade barriers (like tariffs), differences in the composition or quality of the " basket of goods" consumed in different countries, the existence of non-tradable goods and services, and capital flows driven by investment opportunities or interest rate differentials. These real-world frictions prevent the perfect and instantaneous adjustment of exchange rates to inflation differentials.
Why is relative PPP important for understanding the cost of living?
While absolute PPP is more directly related to comparing the cost of living at a specific moment, relative PPP is important because it shows how changes in inflation affect the relative cost of living over time across borders. If your home country has higher inflation, relative PPP suggests your currency's international purchasing power will erode unless the exchange rate adjusts to compensate, effectively making imported goods more expensive in your local currency.