Relative Purchasing Power Parity (RPPP)

Relative purchasing power parity (RPPP) is an extension of purchasing power parity (PPP) that links differences in inflation between two countries to proportional changes in their exchange rate over time. It provides a theoretical framework for how inflation differentials should affect currency values and real purchasing power across borders.

Key takeaways

• RPPP states that the percentage change in an exchange rate between two currencies should equal the difference in their inflation rates.
• It is a dynamic version of PPP and complements absolute PPP (APPP), which compares static price levels.
• RPPP is useful for long-term exchange-rate expectations but has practical limitations from market frictions, non‑tradable goods, and data issues.
• Real-world exchange rates often deviate from RPPP predictions because of speculation, trade barriers, and imperfect competition.

Theoretical basis

• PPP originates from the law of one price: identical tradable goods should have the same price in different countries once expressed in a common currency.
• Absolute PPP compares price levels (a market basket) across countries to determine an equilibrium exchange rate.
• Relative PPP focuses on changes: if country A’s inflation rate exceeds country B’s by x percentage points over a period, country A’s currency should depreciate roughly by x percent relative to country B’s currency during that period.

Simple formulas

• Absolute PPP (price ratio): PPP exchange rate ≈ Price in currency A / Price in currency B.
• Relative PPP (approximate change): Percentage change in exchange rate ≈ Inflation rate (home) − Inflation rate (foreign).
  (In words: the currency of the higher‑inflation country tends to depreciate by the inflation differential.)

Practical example

If average prices rise 3% in the U.S. and 6% in Mexico over a year, RPPP implies a 3 percentage-point depreciation of the Mexican peso versus the U.S. dollar (or a 3% appreciation of the dollar) to preserve relative purchasing power.

Limitations and challenges

RPPP relies on simplifying assumptions that often do not hold in practice:
* Perfect competition and free arbitrage rarely exist; market power and frictions distort prices.
* Goods and services are not perfectly homogeneous across countries (quality, branding, preferences).
* Transportation costs, tariffs, and other trade barriers affect relative prices.
* Many goods and services are non‑tradable (housing, local services), so domestic inflation need not transmit to tradeable prices.
* Data quality and timing differences can make measured inflation and price levels imprecise.
* Short‑term exchange rates are heavily influenced by capital flows, speculation, and market sentiment, producing deviations from RPPP.

Relative vs. absolute PPP

• Absolute PPP compares absolute price levels and implies a fixed exchange-rate relationship based on a common basket of goods.
• Relative PPP focuses on the rate of change in prices (inflation) and predicts proportional exchange‑rate changes over time.
• Absolute PPP is a stronger and less realistic assumption; relative PPP is more flexible and oriented toward dynamic adjustments.

Practical use

RPPP is most useful as a long‑run benchmark for exchange‑rate behavior and for PPP‑adjusted comparisons of incomes and living standards. It is less reliable for short‑term forecasting or when structural differences between economies are substantial.

Conclusion

Relative purchasing power parity explains how inflation differentials should, in theory, drive proportional exchange‑rate movements to preserve international purchasing power. While conceptually important for macroeconomic analysis, its practical application requires caution due to market imperfections, non‑tradable goods, trade costs, and other real‑world factors that cause actual exchange rates to deviate from theoretical predictions.