What Is Relative Purchasing Power Parity (RPPP) in Economics?

What Is Relative Purchasing Power Parity (RPPP)?

Relative purchasing power parity (RPPP) is an expansion of the traditional purchasing power parity (PPP) theory to include changes in inflation over time. Purchasing power is the power of money expressed by the number of goods or services that one unit can buy, and which can be reduced by inflation. RPPP suggests that countries with higher rates of inflation will have a devalued currency.

Understanding Relative Purchasing Power Parity (RPPP)

​​​​​​​According to relative purchasing power parity (RPPP), the difference between the two countries’ rates of inflation and the cost of commodities will drive changes in the exchange rate between the two countries.

RPPP expands on the idea of purchasing power parity and complements the theory of absolute purchasing power parity (APPP). The APPP concept declares that the exchange rate between the two nations will be equal to the ratio of the price levels for those two countries, and APPP is discussed later in this article.

Purchasing Power Parity in Theory

Purchasing power parity (PPP) is the idea that goods in one country will cost the same in another country, once their exchange rate is applied. According to this theory, two currencies are at par when a market basket of goods is valued the same in both countries.

The comparison of prices of identical items in different countries will determine the PPP rate; however, an exact comparison is difficult due to differences in product quality, consumer attitudes, and economic conditions in each nation. Also, purchasing power parity is a theoretical concept that may not be true in the real world, especially in the short run.

Dynamics of RPPP

RPPP is essentially a dynamic form of PPP, as it relates the change in two countries’ inflation rates to the change in their exchange rate. The theory holds that inflation will reduce the real purchasing power of a nation's currency. Thus if a country has an annual inflation rate of 10%, that country's currency will be able to purchase 10% less real goods at the end of one year.

RPPP also complements the theory of absolute purchasing power parity (APPP), which maintains that the exchange rate between two countries will be identical to the ratio of the price levels for those two countries.

This concept comes from a basic idea known as the law of one price. This theory states that the real cost of a good must be the same across all countries after the consideration of the exchange rate.

Example of RPPP

Suppose that over the next year, inflation causes average prices for goods in the U.S. to increase by 3%. In the same period, prices for products in Mexico increased by 6%. We can say that Mexico has had higher inflation than the U.S. since prices there have risen faster by three points.

According to the concept of relative purchase power parity, that three-point difference will drive a three-point change in the exchange rate between the U.S. and Mexico. So we can expect the Mexican peso to depreciate at the rate of 3% per year, or that the U.S. dollar should appreciate at the rate of 3% per year.

Limitations of RPPP

Users of RPPP information must be mindful of several limitations in the inherent process of calculating RPPP. Some of the limitations include:

• Inaccurate Assumption of Perfect Competition. RPPP assumes perfect competition in all markets which is often not the case in the real world. Imperfect competition, market distortions, and barriers to trade can lead to deviations from RPPP.
• Inaccurate Assumptions that Goods Are Homogeneous. RPPP assumes that goods and services are identical across countries, which is rarely true in reality. Differences in product quality, branding, and consumer preferences can affect price levels.
• Excluded Transport Costs and Trade Barriers: RPPP does not consider transportation costs or trade barriers, which can significantly impact the prices of internationally traded goods and create deviations from parity.
• Not All Goods Are Tradeable: RPPP focuses on tradable goods and services, but many items are not easily traded across borders (e.g., housing, local services). These non-traded goods can create disparities in price levels.
• Limited Data and Timing: Accurate and timely data on price levels can be challenging to obtain, especially in developing countries, making it difficult to apply RPPP accurately.

RPPP vs. APPP

There's a couple of differences between relative purchasing power parity and absolute purchasing power parity (APPP). First, PPP is primarily concerned with comparing the relative price levels of two or more countries to determine their exchange rates. Absolute PPP is a simpler concept that focuses on the absolute price levels within a single country.

Second, PPP suggests that exchange rates should adjust over time to equalize the purchasing power of currencies, allowing for a more accurate representation of the real exchange rate. APPP implies that exchange rates should be fixed or constant based on the ratio of absolute price levels between two countries.

Last, PPP takes into account changes in price levels over time while APPP does not. Because APP assumes that exchange rates should always be at a constant ratio, it does not account for inflation.

The Bottom Line

Relative purchasing power parity is an economic theory that suggests exchange rates between two countries' currencies should adjust over time to reflect differences in their price levels. According to PPP, if one country experiences higher inflation than another, its currency should depreciate to maintain the same purchasing power across borders, promoting equilibrium in international trade.