Question

Purchasing Power Parity and Monetary Models of Exchange Rates

Explain the difference between absolute and relative PPP. Why might the latter be more realistic?

Answer 1

THE ABSOLUTE PPP

The absolute PPP is similar to the Law of One Price. The concept of the Law of One Price means that the prices of the same products in different countries should be equal when they’re measured in a common currency. Consider the dollar–British pound exchange rate. The absolute PPP indicates the following:

where $/£, PUS, and PUK indicate the dollar-British pound exchange rate, the price level in the U.S., and the price level in the U.K., respectively. Note that the absolute PPP can also be shown as the equality of the price levels in both countries where, using the dollar-British pound exchange rate (E), the U.K. price level is expressed in dollars:

PUS = PUK x E

Therefore, for the absolute PPP to hold, the dollar–British pound exchange rate should reflect the ratio of the price levels in the U.S. (PUS) and the U.K. (PUK).

THE RELATIVE PPP

The relative PPP, on the other hand, indicates that the changes in the dollar–British pound exchange rate reflect the changes in the ratio of the U.S. and U.K. price levels (PUS and PUK):

Note the difference between the absolute and relative PPP. The absolute PPP indicates that the exchange rate has to reflect the ratio of two countries’ price levels. However, this is not easy.

In reality, there are market imperfections such as nontransferable inputs, transportation costs, tariffs, quotas, and so forth. Therefore, the relative PPP takes these market imperfections in consideration and relaxes the relationship between the exchange rate and the price levels of two countries. It does so by considering the relationship between the changes in the exchange rate and the changes in the ratio of the price levels.

All the relative PPP requires is the changes in the exchange rate equal the changes in the ratio of the price level.