Relative purchasing power parity

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Relative purchasing power parity (RPPP) is the idea that exchange rate changes reflect differences in inflation between two countries. It’s a dynamic version of the idea that price levels should align across currencies over time.

Imagine Country A uses A$ and Country B uses B$, with the exchange rate S as the amount of B$ per A$. If a basket costs P_t in A$ in period t, the same basket costs Q_t in B$ in period t. RPPP says Q_t and P_t are tied by a constant factor over time, so changes in the exchange rate offset price changes. In practical terms, you can think of the theory as: the percentage change in the exchange rate is roughly the difference between inflation in Country A and inflation in Country B.

A simple example: if prices rise by 3% in the United States and by 1% in the European Union, the euro price of the US basket should rise by about 2%, which means the USD would depreciate by roughly 2% against the EUR.

Important points:
- The relationship is an approximation. For small changes, the math is close; for large movements, the exact formula should be used.
- Relative PPP concerns changes (how prices and exchange rates move over time) rather than the absolute price levels. Absolute PPP would say price levels should be equal when expressed in a common currency, and it implies relative PPP, but the reverse isn’t necessarily true.
- Absolute PPP is more likely to hold for easily tradable goods (like gold) and less so for goods and services that are hard to move due to transport and other costs.