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What Is Relative Purchasing Power Parity (RPPP) in Economics?
By JAMES CHEN Updated September 24, 2023
Reviewed by MICHAEL J BOYLE
Fact checked by SUZANNE KVILHAUG Investopedia / Julie Bang
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. KEY TAKEAWAYS TRADE
Relative purchasing power parity (RPPP) is an economic theory that TABLE OF CONTENTS
states that exchange rates and inflation rates (price levels) in two
countries should equal out over time.
Relative PPP is an extension of absolute PPP in that it is a dynamic (as
opposed to static) version of PPP.
While PPP is useful in understanding macroeconomics in theory, in
practice RPPP does not seem to hold true over short time horizons.
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. FAST FACT
In 2023, the purchasing power index of the United States is 115.75. [ 1] Dynamics ofRPPP TRADE
RPPP is essentially a dynamic form of PPP, as it relates the change in two
TABLEcountries’ inflation ra OF CONTENTS
tes 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 TRADE can affect price levels.
Excluded Transport Costs and Trade Barriers: RPPP does not consider TABLE OF CONTENTS
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.
Important: Exchange rates can also be influenced by speculative
trading and market sentiment; therefore, actual exchange rates may
deviate from RPPP calculations. 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.
What Is the Formula for Purchasing Power Parity?
The formula for purchasing power parity (PPP) is Cost of Good X in Currency 1 /
Cost of Good X in Currency 2. This allows an individual to make comparisons of
currencies and the value of a basket of goods they can buy. TRADE
What Country Has the Highest Purchasing Power? TABLEAcc OF ording to the c CONTENTS
rowdsourced database Numbeo, Luxembourg has the highest
purchasing power with a purchasing power index number of 127.1 in 2023.
Other top countries include Qatar (123.6), United Arab Emirates (123.4), and
Switzerland (118.7). The lowest country in 2023 is Nigeria (8.4).[ ] 1
Why Is Purchasing Power Parity Important?
Purchasing power parity is important because it allows economists to compare
two different economies, primarily the economic productivity and the standard
of living among nations. It seeks to equalize currencies to determine the value of a basket of goods. 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. ARTICLE SOURCES Related Terms
Big Mac PPP: Overview, Calculations, Disadvantages
The Big Mac PPP is a survey done by The Economist that examines the purchasing power
of various currencies based on the relative price of a Big Mac. more
Starbucks Index: What it is, How it Works, Criticisms
The Starbucks Index is a measure of purchasing power parity comparing the cost of a tall
latte in local currency against the U.S. dollar in 16 countries. more
Burgernomics: What It Means, How It Works
Burgernomics refers to the Economist's Big Mac Index, which tracks purchasing power
parity using the cost of a McDonald's Big Mac as the price benchmark. more
Gross Domestic Product (GDP) Formula and How to Use It
What are the main advantages and the drawbacks of operating with a ful y fixed exchange rate?
Advantages of Ful y Fixed Exchange Rates:
1. Price Stability: A fixed exchange rate system provides a high degree of price
stability since fluctuations in the exchange rate are minimized. This stability can help
control inflation and provide a predictable environment for businesses and consumers.
2. Trade Confidence: Businesses can plan for transactions without worrying about
sudden currency value changes, making cross-border trade more predictable and manageable.
3. Reduced Exchange Rate Risk: Fixed exchange rates eliminate the currency risk
associated with fluctuating exchange rates. This stability can be particularly beneficial
for companies engaged in long-term contracts, investments, and trade.
4. Foreign Investment: A stable exchange rate can attract foreign investment.
Investors may be more inclined to invest in a country with predictable currency
values, reducing the risk associated with currency fluctuations.
Drawbacks of Ful y Fixed Exchange Rates:
1. Lack of Flexibility: One of the main drawbacks of a ful y fixed exchange rate system
is the lack of flexibility in responding to external economic shocks. Countries cannot
independently adjust their exchange rates to address changing economic conditions.
2. Loss of Monetary Policy Autonomy: The country may be forced to adopt monetary
policies that are not necessarily suited to its specific economic circumstances.
3. Balance of Payments Issues: In a fixed exchange rate system, a country's balance
of payments must be maintained through other means, such as fiscal policy or
controls on capital flows. Persistent imbalances can lead to pressures on the currency peg.
4. Speculative Attacks: Fixed exchange rate systems can be vulnerable to speculative
attacks if investors believe that the currency is overvalued or if there are concerns
about the country's ability to maintain the peg.
5. Dependence on Reserves: To maintain a fixed exchange rate, a country needs to
have sufficient foreign exchange reserves. If reserves are inadequate, the country
might struggle to defend the peg during times of market stress.
Functions of a Floating Exchange Rate
A floating exchange rate functions in an open market where speculations, along with
demand and supply forces, drive the price. Floating exchange rate structures mean that
changes in long-term currency prices represent comparative economic strength and
differences in interest rates across countries. Changes in the short-term floating exchange
rate represent disasters, speculations, and the daily supply and demand of the currency.
Benefits of a Floating Exchange Rate
1. Stability in the balance of payments (BOP)
A balance of payments is in the statement of transactions between entities of a country and
the entities of the rest of the world over a time period. In theory, any imbalance in that
statement automatical y changes the exchange rate.
For example, if the imbalance is a deficit, it would cause the currency to depreciate. The
country’s exports would become cheaper, resulting in an increase in demand and eventually
attaining equilibrium in the BOP.
2. Foreign exchange is unrestricted
Floating exchange rate currencies can be traded without any restrictions, unlike currencies
with fixed exchange rates. Hence, governments and banks do not need to resort to a
continuous management process. 3. Market efficiency enhances
A country’s macroeconomic fundamentals affect the floating exchange rate in global
markets, influencing the flow of portfolios between countries. Thus, floating exchange rates
enhance the efficiency of the market.
4. Large foreign exchange reserves not required
For a floating exchange rate, central banks are not required to keep large foreign currency
reserve amounts for defending the exchange rate. Hence, the reserves can be utilized for
promoting economic growth by importing capital goods. 5. Import inflation protected
Countries with fixed exchange rates face the problem of importing inflation through surpluses
of the balance of payments or higher prices of imports. However, countries with floating
exchange rates do not face such a problem.
Limitations of a Floating Exchange Rate
1. Exposed to the volatility of the exchange rate
Floating exchange rates are prone to fluctuations and are highly volatile by nature. A
currency value against another currency may deteriorate only in one trading day.
Furthermore, the short-term volatility in a floating exchange rate cannot be explained
through macroeconomic fundamentals.
2. Restricted economic growth or recovery
The lack of control over floating exchange rates can limit economic growth or recovery. The
negative currency exchange rate movements may lead to serious issues. For example, if the
dol ar rises against the euro, it wil be more difficult to export to the eurozone from the U.S. 3. Existing issues may worsen
If a country is suffering from economic issues, such as unemployment or high inflation,
floating exchange rates may intensify the existing problems. For example, depreciation of a
country’s currency already suffering from high inflation will cause inflation to increase further
due to an increase in demand for goods. Moreover, expensive imports may worsen the country’s current account.
What Is an Example of a Floating Exchange Rate?
An example of a floating exchange rate would be on Day 1, 1 USD is equal to 1.4 GBP. On
the next day, 1 USD is equal to 1.6 GBP, and on day three, 1 USD is equal to 1.2 GBP. This
shows that the value of the currencies float, meaning they change constantly due to the
supply and demand of those currencies. The opposite would be a fixed currency, where 1
USD would always equal 1.4 GBP, for example.
FACTOR THAT EFECT THE EXCHANGE RATE 1. Inflation
Inflation is a general rise in prices in an economy, i.e., goods, and services and is usual y expressed in percentages.
If, for example, inflation was lower in the UK, the purchasing power of the Pound Sterling
would increase relative to other currencies. UK exports become more competitive and the
demand to purchase Pound Sterling for UK goods wil increase.
In December 2022, the inflation rate in the European Union was 10.4 percent, with prices
rising fastest in Hungary, which had an inflation rate of 25 percent.
As a result, the Hungarian forint is amongst the worst performing currencies in Central Europe since January 2022.
Research by BNP Paribas indicates that the forint has respectively lost 11 and 23 % of its
value against the Euro and the dol ar. It must be stated however that inflation is just one of
the contributory factors here. 2. Interest rates
There is also a strong correlation between inflation, interest rates and exchange rates.
Governments and Central Banks have the authority to influence exchange rates by
increasing interest rates. An example of this is “Hot money”: the higher the interest rate the
more attractive the currency offer is to foreign investors.
This involves investors rapidly and frequently moving money from a currency with lower
interest rates to a country with higher interest rates, giving a quick return on investment. 3. Government/Public debt
A country’s debt rating is also a factor that influences its currency exchange rate.
Public sector projects sometimes require large-scale deficit financing which boosts the domestic economy.
However, foreign investors are less likely to invest in countries with large public deficits and government debt.
Fear of a debt default can result in the sel ing of bonds denominated in that currency by
investors, resulting in a fal in the value of the exchange rate.
Governments may also need to print money to pay parts of a large debt, resulting in inflation. 4. Political stability
The strength of a currency can also be influenced by the political stability of a particular country.
Foreign investors are more attracted to invest in countries displaying a lower propensity for
political turmoil. This injection of foreign investment leads to an appreciation of the domestic currency.
Conversely, unpredictable events leading to unstable conditions in a country mean less
foreign investment natural y leading to a depreciation in the domestic currency.
In October 2022, Britain was plunged into economic and political uncertainty fol owing the
resignation of the then Prime Minister Liz Truss after only 49 days in office. Her vast planned
tax cuts crashed the pound and sent borrowing costs soaring.
The ‘mini budget’ announced by former Chancellor Kwasi Kwarteng would have required an
unprecedented extra £411 bil ion in public borrowing over the fol owing five years, pushing
Britain into a crisis not seen since the 2008 financial crash. 5. Economic recession
In theory, when a country enters a recession there is normal y a depreciation of its currency. Why so?
Firstly, it is commonplace for interest rates to fal in a recession and when this happens, we
see a flow of money out of the country to countries with higher interest rates.
If for example, Canada entered a recession and money started to flow out of the country, its
people would sel Canadian dol ars to buy other currencies resulting in a fal in the value of CAD (Canadian dol ar).
It must be noted that economic and political events in other countries wil also influence how
a domestic currency moves in times of recession.