Question

What is absolute PPP? What is the law of one price? What is the difference between

these two concepts? If absolute PPP holds, would the law of one price necessarily hold

for every good and service? Explain.

What is relative PPP? Derive this condition from absolute PPP. If absolute PPP holds,

does relative PPP hold? Is the converse true? Explain.

Answer 1

Absolute PPP tells us that the price of a basket of goods should be equal in all markets regardless of the currency used to purchase it .

Law of one price tells us that the price of one good in a country must be equal to the price of same good in other countries after taking in consideration the exchange rate between the countries .

Absolute PPP is an extreme form of law of one price . The idea of absolute PPP is based on this law . As the definition goes if absolute PPP holds then the law of one price holds definitely because goods are price equally in all markets .

Relative PPP is dynamic version of absolute PPP . In relative the change in exchange rate should be proportional to the relative change in price levels .

If absolute PPP holds then relative PPP must also hold . But the converse need not be true .

We can imagine a situation when a basket always costs a fixed amount more say by 20% in one country than in the other in common currency . Absolute PPP will fail but relative PPP will hold in this case .

If law of one price holds , then :

Absolute PPP :

Relative PPP :