Relative purchasing power parity (RPPP) goes beyond the traditional concept of purchasing power parity (PPP) by incorporating changes in inflation over time. Here’s a look at the key components and applications of RPPP.
Key Insights
- RPPP In Brief: RPPP is an economic theory that suggests that the differential inflation rates between two countries will drive exchange rate adjustments to maintain purchasing power parity.
- Dynamic vs. Static: Unlike absolute PPP, RPPP is more dynamic and acknowledges the role of inflation trends over time.
- The Practical Aspect: While useful in macroeconomic theory, applying RPPP in short-term scenarios may not always yield accurate predictions.
Grasping the Essence of RPPP
RPPP asserts that the disparities in inflation rates and commodity prices between countries will prompt corresponding changes in their exchange rates. Essentially, it complements the notion of absolute purchasing power parity (APPP), which states that the exchange rate between two nations equates to their price level ratio.
The Theory Behind Purchasing Power Parity
PPP posits that identical goods in different countries should cost the same once you account for the exchange rate between currencies. The central idea here is that two currencies are equivalent when a standard basket of goods has the same price in both countries. In reality, factors like product quality and consumer behavior can complicate perfect parity.
Example 2023: The purchasing power index for the United States stands at 115.75.
Dynamics of RPPP
RPPP effectively extends PPP into a more dynamic realm, focusing on how inflation rates impact currency purchasing power differently. If a country’s inflation rate is 10% over a year, its currency would theoretically buy 10% fewer goods by year-end.
Complementing this is the APPP theory, which maintains that exchange rate ratios should mirror the ratio of price levels between countries. This relates closely to the “law of one price”—the same good should have the same real cost worldwide when taking the exchange rate into account.
Illustrative Example of RPPP
Consider a scenario where inflation causes average prices in the U.S. to rise by 3%, while in Mexico, prices go up by 6%. Here, Mexico’s higher inflation rate by three points implies, per RPPP, a three-point depreciation in the Mexican peso relative to the U.S. dollar.
Recognizing the Limitations of RPPP
Employing RPPP requires an awareness of its inherent assumptions and limitations:
- Perfect Competition: It assumes flawless market competition, which is rare due to real-world market imperfections.
- Homogeneous Goods: Products are assumed to be identical across countries, ignoring branding and quality differences.
- Ignored Costs: Transport costs and trade barriers aren’t factored in, yet they significantly affect international goods pricing.
- Non-tradable Goods: Many items like housing and local services don’t easily cross borders, skewing parity assessments.
- Data Accuracy & Timeliness: Reliable data, particularly from developing nations, can be hard to obtain.
Exchange rates are also susceptible to speculative trading, so actual rates may stray far from RPPP-predicted rates.
Comparing RPPP and APPP
Exploring the distinctions:
- PPP vs. APPP: While PPP explores the relativity of price levels across countries, APPP focuses on absolute within-country price levels.
- Exchange Rate Adjustments: PPP accounts for evolving price levels to mirror realism in exchange rates, whereas APPP suggests a constant ratio.
- Inflation Consideration: PPP incorporates changes over time, unlike the static APPP outlook.
The formula for PPP
To compute PPP:
Cost of Good X in Currency 1 / Cost of Good X in Currency 2
This provides a currency comparison reflecting basket-of-goods value.
Global Purchasing Power Ranking
Based on a crowdsourced model, Luxembourg leads with a purchasing power index of 127.1 in 2023, followed closely by Qatar (123.6), UAE (123.4), and Switzerland (118.7). Nigeria ranks lowest with an index of 8.4.
The Importance of Purchasing Power Parity
PPP is pivotal for economists to compare the economic productivity and standard of living across different countries, striving for currency equalization to evaluate a basket of goods’ true value.
Conclusion
Relative purchasing power parity underscores the idea that exchange rates between two currencies should adjust over time to reflect differing inflation rates, facilitating an equilibrium in international trade.
Related Terms: Absolute Purchasing Power Parity (APPP), inflation, exchange rate, currency depreciation.
