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What Is the Difference Between Relative PPP and Absolute PPP?

Defining and Understanding PPP


Q: What is the difference between relative purchasing power parity (PPP) and absolute PPP?

A: Thank you for your terrific question!

To distinguish between the two, first consider the more common form of purchasing power parity, Absolute PPP.

Absolute PPP

Absolute purchasing power parity is the kind discussed in A Beginner's Guide to Purchasing Power Parity Theory (PPP Theory). Specifically, it implies that "a bundle of goods should cost the same in Canada and the United States once you take the exchange rate into account". Any deviations from this (if a basket of goods is cheaper in Canada than in the United States), then we should expect relative prices and the exchange rate between the two countries to move towards a level at which the basket of goods have the same price in the two countries.

The idea is expressed in more detail at A Beginner's Guide to Purchasing Power Parity Theory (PPP Theory).

Relative PPP

Relative PPP describes differences in the rates of inflation between two countries. Specifically, suppose the rate of inflation in Canada is higher than that in the US, causing the price of a basket of goods in Canada to rise. Purchasing power parity requires the basket be the same price in each country, so this implies that the Canadian dollar must depreciate vis-a-vis the U.S. dollar. The percentage change in the value of the currency should then equal the difference in the inflation rates between the two countries.

PPP Conclusion

I hope this helps clarify the issue. Both forms of purchasing power parity evolve from the same premise - that large disparities in the prices of goods between two countries is unsustainable, since it creates arbitrage opportunities to move goods across borders.

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