Relative Purchasing Power Parity (RPPP)

Definition of Relative Purchasing Power Parity (RPPP)§

Relative Purchasing Power Parity (RPPP) is an economic theory stating that the change in exchange rates over time between two countries is determined by the relative changes in price levels due to inflation rates. In simple terms, if one country experiences a higher inflation rate than another, its currency will depreciate relative to that of the lower-inflation country.

RPPP vs Absolute Purchasing Power Parity (APP)§

Examples of RPPP in Action§

1. Inflation Rates Impacting Currency:

   • Suppose Country A has an annual inflation rate of 5%, while Country B has 2%. According to RPPP, Country A’s currency should depreciate relative to Country B’s currency over time.

2. Exchange Rate Calculation:

   • If the initial exchange rate of A/B is 1.5, after one year, assuming the inflation differential is constant, RPPP suggests calculating the expected future exchange rate as follows:
   • $$ER_{future} = ER_{current} \times \frac{1 + \text{Inflation Rate}_A}{1 + \text{Inflation Rate}_B}$$
   • From the example above:
   • $$ER_{future} = 1.5 \times \frac{1 + 0.05}{1 + 0.02} \approx 1.5 \times 1.02941 \approx 1.544$$

Related Terms§

• Purchasing Power Parity (PPP): A theory suggesting that in the long run, exchange rates should adjust so that identical goods in different countries have the same price when expressed in a common currency.
• Inflation Rate: The annual percentage increase in prices, indicating how much more expensive a set of goods and services has become over a certain period.

Humorous Quotes and Fun Insights§

• “Economics is the only field in which two people can get rich by proving that the other is wrong.” – Anonymous 💸
• Fun Fact: The concept of PPP was put forward in 16th-century Europe, long before texts with ‘For Dummies’ hit the shelves!

Frequently Asked Questions§

What is the main assumption behind Relative Purchasing Power Parity?§

It assumes that inflation differential affects the exchange rate over time.

Does RPPP work in the short term?§

No! It generally fails to hold in short time periods due to market inefficiencies and unexpected economic events.

Can RPPP help in currency forecasting?§

In the long run, yes! It can provide a theoretical framework for understanding currency valuation but often lacks short-term predictive power.

Resources for Further Study§

• Books:

  • “International Economics” by Paul Krugman and Maurice Obstfeld
  • “Exchange Rate Dynamics” by David Onofrio

• Online Resources:

  • Investopedia on Purchasing Power Parity
  • Khan Academy - International Trade

Test Your Knowledge: Relative Purchasing Power Parity Quiz§

Thank you for diving into the perplexing and often amusing world of Relative Purchasing Power Parity. Remember, even the economists who know the theories best are still trying to balance their own purchasing power at the local cafe! Stay curious! 🌍💡