Relative purchasing power parity
Relative purchasing power parity is an economic theory which predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. It is a dynamic version of the absolute PPP theory.[1]
Explanation
Suppose that the currency of Country A is called the A$ (A-dollar) and the currency of country B is called the B$.
The theory states that if the price P in country A of a basket of commodities and services is P A-dollars, then the price Q of the same basket in country B will be C×P A-dollars, where C is a constant which does not vary over time, or, equivalently, C×P×S B-dollars, where S is the (variable) number of B-dollars required to buy one A-dollar, i.e. the exchange rate.
If (1) and (2) denote two different dates, then it follows that
and hence
or, in words, the factor representing the movement in market exchange rates is equal to the ratio of the inflation factors (changes in price levels) of the two countries (as one would intuitively expect).
Absolute purchasing power parity occurs when C=1, and is a special case of the above.
According to this theory, the change in the exchange rate is determined by price level changes in both countries. For example, if prices in the United States rise by 3% and prices in the European Union rise by 1% the purchasing power of the EUR should appreciate by approximately 2% compared to the purchasing power of the USD (equivalently the USD will depreciate by about 2%).
Note that it is incorrect to do the calculation by subtracting these percentages – one must use the above formula, giving = 0.98058, i.e. a 1.942% depreciation of the USD. With larger price rises, the difference between the incorrect and the correct formula becomes larger.[2]
Absolute purchasing power parity
Commonly called absolute purchasing power parity, this theory assumes that equilibrium in the exchange rate between two currencies will force their purchasing powers to be equal. This theory is likely to hold well for commodities which are easily transportable between the two countries (such as gold, assuming this is freely transferable) but is likely to be false for other goods and services which cannot easily be transported, because the transportation costs will distort the parity.