key term - Relative Purchasing Power Parity (Relative PPP)

Definition

Relative Purchasing Power Parity (Relative PPP) is a theory in international economics that states the exchange rate between two currencies should adjust to equalize the relative purchasing power of the two countries. It suggests that the exchange rate between two countries will move to make the purchasing power of a basket of goods the same in both countries when expressed in the same currency.

5 Must Know Facts For Your Next Test

1. Relative PPP suggests that the exchange rate will adjust to offset differences in inflation rates between two countries, keeping the purchasing power of the currencies equal.
2. Relative PPP is a more realistic and practical version of the Absolute PPP theory, as it accounts for differences in the composition of consumption baskets and productivity levels between countries.
3. Relative PPP is used to predict long-run movements in exchange rates, as it assumes that over time, exchange rates will adjust to equalize the purchasing power of currencies.
4. Deviations from Relative PPP can occur in the short-run due to factors such as trade barriers, transportation costs, and market imperfections.
5. Relative PPP is an important concept in understanding the dynamics of foreign exchange markets and the determination of exchange rates.

Review Questions

• Explain how the relative PPP theory relates to the demand and supply shifts in foreign exchange markets.
  • According to the relative PPP theory, the exchange rate between two currencies should adjust to equalize the relative purchasing power of the two countries. This means that if one country experiences higher inflation than another, the exchange rate should depreciate to offset the loss in purchasing power and maintain the relative purchasing power parity. The demand and supply of foreign exchange will shift in response to these relative price changes, leading to adjustments in the exchange rate to restore the relative PPP.
• Analyze the differences between the absolute PPP and relative PPP theories and their implications for understanding exchange rate determination.
  • The absolute PPP theory states that the exchange rate should equalize the price of an identical basket of goods and services in two countries when expressed in the same currency. In contrast, the relative PPP theory acknowledges that differences in consumption baskets, productivity levels, and other factors can lead to deviations from absolute PPP. Relative PPP suggests that the exchange rate will adjust to offset differences in inflation rates between countries, keeping the purchasing power of the currencies equal. This makes relative PPP a more realistic and practical theory for understanding the long-run dynamics of exchange rate determination, as it accounts for the complexities of real-world economic conditions.
• Evaluate the role of relative PPP in predicting long-run movements in exchange rates and discuss the limitations of the theory in explaining short-run exchange rate fluctuations.
  • The relative PPP theory is useful for predicting long-run trends in exchange rates, as it suggests that over time, exchange rates will adjust to equalize the purchasing power of currencies across countries. However, the theory has limitations in explaining short-run exchange rate fluctuations, which can be influenced by factors such as trade barriers, transportation costs, and market imperfections that cause deviations from relative PPP. In the short-run, other factors like interest rate differentials, speculative capital flows, and political and economic uncertainties can also play a significant role in determining exchange rate movements, which are not fully captured by the relative PPP theory. Therefore, while relative PPP provides a valuable framework for understanding long-term exchange rate dynamics, it should be considered alongside other theories and factors to gain a more comprehensive understanding of exchange rate determination.

Related terms

Absolute Purchasing Power Parity (Absolute PPP):

Absolute Purchasing Power Parity is the theory that the exchange rate between two currencies should equalize the price of an identical basket of goods and services in the two countries when expressed in the same currency.

Exchange Rate:

The exchange rate is the price of one currency in terms of another currency, or the rate at which one currency can be exchanged for another.

Inflation:

Inflation is the sustained increase in the general price level of goods and services in an economy over time, resulting in a decrease in the purchasing power of a given currency.