Relative Purchasing Power Parity (RPPP) Definition
Relative Purchasing Power Parity (RPPP) refers to the expansion of the purchasing power parity (PPP) theory to involve inflation changes as time goes by. The amount of goods and services that one power of money can purchase is referred to as purchasing power. It also implies the reduction of this money power by inflation. According to the RPPP, nations with higher inflations will have a lesser valued currency compared to their counterparts with lower inflation rates.
A Little More on What is Relative Purchasing Power Parity (RPPP)
The relative purchasing power parity theory states that the exchange rate between two nations is driven mostly by the different rates of inflation and the cost of products in both nations. This theory is based on the idea of purchasing power theory and propels the absolute purchasing power parity (APPP). The APPP states that ratio of price levels for two nations involved in trades would be equivalent to their currency exchange rates.
Purchasing Power Parity (PPP) is an idea that the cost of goods in one nation will be equivalent to the cost of the same good in another nation if their exchange rate is applied. This concept drives the notion that two countries have equal currencies if the cost of goods is the same in both countries. The purchasing power parity is determined by the comparison of the price s of similar products in different countries. However, it is quick to dismiss this concept in the real world as purchasing power parity doesn’t account for price changes in the short-run and long-run. That is to say, if a nation faces a minute issue which increases the cost of goods to be higher than that of another nation for just a period of time, using PPP, one will be quick to misjudge such nation’s currency value since it is selling products higher than the price of other nations for just a while. Also, another reason to dismiss PPP is due to the fact that it doesn’t account for product quality, consumers’ behavior, and economic performance of each nation.
RPPP is a dynamic form of PPP as it compares two nations’ change in inflation rate to the difference in their currency exchange rates. This theory thus suggests that an increase in the inflation rate of Country A will reduce its buying strength in the exchange market. Thus, if Country A’s inflation rate were to increase by 13%, the number of real goods they’ll be able to purchase in the market would reduce by 13%.
The absolute purchasing power parity is also complemented by the relative purchasing power parity. The APPP states that the currency exchange rate between Country A and Country B is equivalent to the level of the price ratio of the two countries. The APPP is derived from the “law of one price”, which states that the actual cost of commodities must be equivalent in all nations for exchange rates to be properly determined or considered.
Illustration of Relative Purchasing Power Parity (RPPP)
Assume that inflation in the U.S. causes the real price of goods to increase by 4%, while it also causes the price of identical goods in Australia to increase by 2%. From the values above, we can clearly see that the U.S. has suffered more inflation because the value has moved faster than that of Australia by 2 points. Thus, the U.S. will have a negative 2 point in the exchange rate between the USD (United States Dollar) and AUD (Australian Dollar). In other words, it is expected that the USD would depreciate at a rate of 2% per annum against the AUD, or the AUD will increase at 2% per annum against the USD.