Table of Contents
- What Is Relative Purchasing Power Parity (RPPP)?
- Key Takeaways
- Understanding Relative Purchasing Power Parity (RPPP)
- Dynamics of RPPP
- Example of RPPP
- Limitations of RPPP
- RPPP vs. APPP
- What Is the Formula for Purchasing Power Parity?
- What Country Has the Highest Purchasing Power?
- Why Is Purchasing Power Parity Important?
- The Bottom Line
What Is Relative Purchasing Power Parity (RPPP)?
Let me explain relative purchasing power parity (RPPP) to you directly: it's an extension of the basic purchasing power parity (PPP) theory, incorporating how inflation changes over time. Purchasing power refers to what one unit of money can buy in terms of goods or services, and inflation erodes that. RPPP indicates that if a country has higher inflation, its currency will devalue accordingly.
Key Takeaways
You should know that RPPP is an economic theory stating that over time, exchange rates and inflation rates between two countries will balance out. It's a dynamic version of absolute PPP, unlike the static one. While PPP helps in theoretical macroeconomics, RPPP doesn't always apply accurately in short-term real-world scenarios.
Understanding Relative Purchasing Power Parity (RPPP)
According to RPPP, the gap in inflation rates between two countries, along with commodity costs, drives shifts in their exchange rate. This builds on absolute purchasing power parity (APPP), where the exchange rate equals the ratio of price levels in those countries—I'll cover APPP more later.
Purchasing power parity in theory means goods should cost the same in different countries once you apply the exchange rate. Currencies are at par when a basket of goods has the same value in both places. Comparing identical items' prices sets the PPP rate, but it's tough due to variations in quality, consumer views, and economic factors. Remember, PPP is theoretical and may not hold, especially short-term.
Dynamics of RPPP
RPPP is a dynamic take on PPP, linking inflation rate changes to exchange rate shifts between countries. Inflation cuts a currency's real purchasing power—so if a country sees 10% annual inflation, its money buys 10% less goods after a year. This complements APPP, which says exchange rates match price level ratios. It stems from the law of one price: a good's real cost should be identical worldwide after exchange adjustments.
Example of RPPP
Consider this example: if U.S. goods prices rise 3% over a year, and Mexico's rise 6%, Mexico has higher inflation by 3 points. RPPP suggests this drives a 3% annual depreciation of the Mexican peso, or a 3% appreciation of the U.S. dollar.
Limitations of RPPP
When using RPPP, you need to be aware of its limitations. It assumes perfect competition, but real markets have imperfections, distortions, and trade barriers that cause deviations. It also presumes goods are identical across countries, which isn't true due to quality, branding, and preferences. Transport costs and barriers aren't factored in, affecting traded goods' prices. Not all goods are tradable—like housing or local services—leading to price disparities. Plus, getting accurate, timely data is hard, especially in developing nations.
RPPP vs. APPP
There are key differences between RPPP and absolute purchasing power parity (APPP). PPP compares relative price levels across countries to set exchange rates, while APPP looks at absolute levels within one country. PPP says rates adjust over time for equal purchasing power, giving a real exchange rate view; APPP implies fixed rates based on price ratios. Finally, PPP accounts for price changes over time, unlike APPP, which ignores inflation and assumes constant ratios.
What Is the Formula for Purchasing Power Parity?
The PPP formula is straightforward: Cost of Good X in Currency 1 divided by Cost of Good X in Currency 2. This lets you compare currencies and what a basket of goods is worth.
What Country Has the Highest Purchasing Power?
Based on 2023 data from Numbeo, Luxembourg tops the list with a purchasing power index of 127.1. Others include Qatar at 123.6, United Arab Emirates at 123.4, and Switzerland at 118.7. Nigeria is the lowest at 8.4.
Why Is Purchasing Power Parity Important?
PPP matters because it helps economists compare economies, looking at productivity and living standards across nations. It equalizes currencies to value a basket of goods accurately.
The Bottom Line
Relative purchasing power parity theory says exchange rates between countries adjust over time to match price level differences. If one has higher inflation, its currency depreciates to keep purchasing power equal across borders, supporting trade equilibrium.
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