Relative purchasing power parity

Relative Purchasing Power Parity is a economic theory which predicts the relationship between the two countries' relative inflation rates and the change in the exchange rate of their currencies.

Explanation

Relative PPP relates the inflation rate (the change of price levels) in each country to the change in the market exchange rate.

${\frac {S_{t}}{S_{t-1}}}={\frac {P_{t}^{*}/P_{t-1}^{*}}{P_{t}/P_{t-1}}}$,

where $S_{t}$ is the spot rate in Foreign Currency/Domestic Currency and $P_{t}$ is the price level in period t (foreign values are marked by an asterisk). This relation is necessary but not sufficient for absolute purchasing power parity.

According to this theory, the change in the exchange rate is determined by price level changes in both countries. For example, if prices in the United States rise by 3% and prices in the European Union rise by 1% the purchasing power of the EUR should appreciate by 2% compared to the purchasing power of the USD (equivalently the USD will depreciate by about 2%).

Note that it is incorrect to do the calculation by subtracting percentages - one must use the above formula, getting 1.01/1.03 = .98, i.e. a 2% depreciation of the USD. With larger price rises, the difference between the incorrect and the correct formula becomes larger.

Absolute Purchasing Power Parity

Commonly called absolute purchasing power parity, it's a theory that uses the long-term equilibrium exchange rate of two currencies to equalize their purchasing power.

See also

Purchasing power parity Exchange rate