What is Relative Purchasing Power Parity?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. Show
Back to:ECONOMIC ANALYSIS & MONETARY POLICY How is Relative Purchasing Power Parity Used?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 nations 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 doesnt 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 As inflation rate were to increase by 13%, the number of real goods theyll 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. Related Topics
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Relative Purchasing Power Parity is an economic theory which predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. It is a dynamic version of the absolute purchasing power parity theory.[1][2] A reason for the prominence of this concept in economic research is the fact that most countries publish inflation data normalized to an arbitrary year, but not absolute price level data. Explanation[edit]Suppose that the currency of Country A is called the A$ (A-dollar) and the currency of country B is called the B$. The exchange rate between the two countries is quoted as , so country A can be regarded as the "home country". The theory states that if the price The last identity can be rewritten for t=1 as and because C is time-invariant, this has to hold for all periods, so This can be further transformed to which is the "exact formulation" of the Relative Purchasing Power Parity. Using the common first-order Taylor approximation to the logarithm for close to , this can be written linearly as where lowercase letters denote natural logarithms of the original variables. Using the first-order approximation again on the definition of the inflation rate from t=1 to t=2 allows us to finally rewrite the equation as which implies that the value of A$ relative to B$ should depreciate (nominally) by (approximately) the same amount that the inflation in country A exceeds inflation in country B. This is quite intuitive, as an agent in country A with a constant real income stream would ceteris-paribus have a higher purchasing power for goods from country B after one period has passed, but the exchange rate adjusts exactly to offset this advantage by making the currency of country B nominally more expensive. Absolute purchasing power parity occurs when C=1, and is a special case of the above. A simple numerical example: If prices in the United States rise by 3% and prices in the European Union rise by 1%, then the price of EUR quoted in USD should rise by approximately 2%, which is equivalent with a 2% depreciation of the USD or an increase in the purchasing power of the EUR relative to that of the USD. Note that the above difference-in-logs equation is based on the first-order approximation of the logarithm and therefore only holds approximately. To obtain the precise value, use the exact formulation , which implies a USD depreciation of relative to the EUR. As the linear approximation to the logarithm deteriorates in the size of the change in the exchange rate or the price level, the exact formulation should be preferred for large deviations. Unlike absolute PPP, relative PPP predicts a relationship between changes in prices and changes in exchange rates, rather than a relationship between their levels. Remember that relative PPP is derived from absolute PPP. Hence, the latter always implies the former: if absolute PPP holds, this implies that relative PPP must hold also. But the converse need not be true: relative PPP does not necessarily imply absolute PPP (if relative PPP holds, absolute PPP can hold or fail). Absolute purchasing power parity[edit]Commonly called absolute purchasing power parity, this theory assumes that equilibrium in the exchange rate between two currencies will force their purchasing powers to be equal. This theory is likely to hold well for commodities which are easily transportable between the two countries (such as gold, assuming this is freely transferable) but is likely to be false for other goods and services which cannot easily be transported, because the transportation costs will distort the parity.[3] See also[edit]
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How do you calculate PPP from GDP?it is calculated by dividing GDP by the corresponding purchasing power parity (PPP), which is an exchange rate that removes price level differences between countries.
What is PPP example?A simple example would be a litre of Coca-Cola. If it costs 2.3 euros in France and 2.00$ in the United States then the PPP for Coca-Cola between France and the USA is 2.3/2.00, or 1.15.
What GDP PPP means?GDP per capita based on purchasing power parity (PPP). PPP GDP is gross domestic product converted to international dollars using purchasing power parity rates. An international dollar has the same purchasing power over GDP as the U.S. dollar has in the United States.
How do you compare PPP of two countries?It is done by equalizing the value of comparable market basket of goods between two countries. This equalizing exchange rate is the PPP exchange rate.
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Rppp formula
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