What is Relative Purchasing Power Parity ?

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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.

Definition

Relative Purchasing Power Parity (RPPP) is an extension of the traditional Purchasing Power Parity (PPP) theory, which includes inflation changes over time. Purchasing power refers to the amount of goods or services that a unit of currency can buy, and inflation reduces purchasing power. RPPP suggests that a country with a higher inflation rate will see its currency depreciate.

Origin

The theory of Purchasing Power Parity was first introduced by classical economists David Ricardo and Gustav Cassel in the early 20th century. Relative Purchasing Power Parity is a further development of this theory, aimed at explaining exchange rate changes due to inflation differences between countries.

Categories and Features

Relative Purchasing Power Parity is mainly used to analyze long-term exchange rate trends. It is characterized by considering the impact of inflation on exchange rates and is applicable to countries with significant inflation rate differences. The advantage of RPPP is that it provides a simple way to predict exchange rate changes, but its disadvantage is that it ignores other factors that may affect exchange rates, such as interest rates and capital flows.

Case Studies

A typical case is the 1970s scenario between the United States and Japan. Due to higher inflation rates in the US compared to Japan, the US dollar depreciated against the Japanese yen. Another example is Venezuela in the 2010s, where extremely high inflation rates led to a significant depreciation of its currency, the bolívar.

Common Issues

Investors often misunderstand RPPP as a tool for short-term exchange rate prediction, but it is more suitable for long-term analysis. Additionally, RPPP overlooks other economic factors affecting exchange rates, which can lead to inaccurate predictions.

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