Question

7.Relative purchasing power parity applications

            a.Define relative purchasing power parity

b.Show the relationship between relative purchasing power parity and the inflation rates in the two countries for which the spot exchange rate is also available.

c.What is the difference between absolute and relative purchasing power parity?

Answer 1

a.) The dynamic version of PPP is the Relative purchasing power parity which relates the changes in the inflation rate of the two countries with the changes in their exchange rates over the same period of time. In simple words, RPPP theory states that exchange rates and inflation rates between two countries should equal out over time. This also means that inflation will reduce the real purchasing power of a country's currency. For example, suppose that over the next year, inflation causes average prices for goods in the U.S to increase by 2%. In the same period, prices for products in India increased by 4%. According to the concept of relative purchasing power parity, that two-point difference will cause a two-point change in the exchange rate between the U.S and India and it can be expected that the Indian rupee should depreciate at the rate of 2% per year (or that the U.S. dollar should appreciate at the rate of 2% per year), and hence the real purchasing power of Indian rupee reduces by the amount of increase in inflation it faced.

b.) RPPP is calculated as : Suppose we compare 2 countries, U.S and U.K, then

, where are the rate of inflation in US and UK respectively.

that is,

It shows that the changes in the dollar–British pound exchange rate reflects the changes in the ratio of the U.S. and U.K. price levels (P_USand P_UK)

c.) Difference between Absolute PPP and Relative PPP : Absolute PPP or the law of one price says that prices of the national basket of identical goods/services are the same between two countries, when the prices are expressed in a common currency unit. It means that market forces will cause the exchange rate to adjust when the prices of national baskets are not equal.

Absolute PPP says that exchange rate has to reflect the ratio of the 2 countries price level. It assumes the same basket of goods across countries, which in reality is not possible. The price indices differ across countries thus making the concept of PPP only a theoritical possibililty. And Even if the goods traded are homogenous, there exists tariffs as well as transactional costs involved, which makes the concept of Absolute PPP weaker in practicality, especially in the short run.

So, we use an expanded version of Absolute PPP, which is Relative PPP, the concept that takes the changes in the exchange rate and the changes in the ratio of price level, i.e it considers price indices of the two countries relative to some period 't'.