Relative Purchasing Power Parity (RPPP)
Candlefocus EditorUnder RPPP, if two currency exchange rates diverge, then adjustments will occur in that country’s inflation rate. Therefore, if one country experiences significant changes in its inflation rate, then the other country’s inflation rate should adjust in order for the two prices to return to their equal relative purchasing power relation.
An example of RPPP at work can be seen in the recent years when the US economy had a weaker currency while emerging economies like India and China had stronger currencies. The predicted outcome of this was that the inflation rate of the US would rise due to the decrease in the purchasing power of the US dollar relative to the Indian and Chinese currencies. As a result, the price of goods and services in the US should increase and their cost should increase. This increase in cost should be offset by an increase in the cost of goods and services in India and China due to their stronger currency.
In theory, the price levels and exchange rates of two countries should return to their original equal purchasing power relationship over time. However, the RPPP does not appear to hold true over short-term horizons. This is due to the fact that it takes time for the adjustments of each of the countries’ inflation rates to take effect. Also, there are other factors, such as wage differentials, which can lead to discrepancies between the purchasing power parity of two countries.
Further, the RPPP model does not take into account factors such as the long-term effects of changes in a given currency’s supply and demand or interest rates. Therefore, the efficacy of RPPP is limited; however, it can still be a useful tool for understanding the relation between exchange rates, inflation rates, and the prices of goods and services in different countries.