Relative purchasing power parity: What Is Relative Purchasing Power Parity RPPP in Economics?
The PPP implied exchange rate would have worked out at 5.58, which is 6.6% lower than the actual exchange rate at the time of 6.08. The OECD produces an annual report that measures the difference between its member countries using PPPs – comparing consumption levels to exchange rates. So, if there is disparity between the exchange rate and PPP rates, then an individual can aim to trade the move toward this central point.
This modification was made because McDonald’s restaurants are only found in three African countries – Morocco, Egypt and South Africa – whereas KFC is found in 20. This means that the purchasing power of various African currencies can be compared to the US dollar, euro and pound. The KFC index was created by Sagaci Research to assess the purchasing power parities of African currencies. The index is based on the Big Mac index, but in this case, the basket of goods being measured is KFC’s original 15-piece bucket. For example, if the UK had an annual inflation rate of 2%, then one unit of pound sterling would be able to purchase 2% less per year. Purchasing power is the value of a currency in terms of the goods or services one unit of it can buy.
PPP measures are widely used by global institutions, such as the World Bank, United Nations, International Monetary Fund and European Union. IG International Limited is part of the IG Group and its ultimate parent company is IG Group Holdings Plc. IG International Limited receives services from other members of the IG Group including IG Markets Limited. The information in this site does not contain investment advice or an investment recommendation, or an offer of or solicitation for transaction in any financial instrument. Discover the range of markets and learn how they work – with IG Academy’s online course.
Explore the markets with our free course
Analysts use global PPP data to assess how changing price levels impact the number of individuals below the poverty line, and readjust the global estimates of how long it will be until poverty ends. In 2011, the PPP adjusted poverty line was set at $1.90 per day – indicating that anyone who earns less than this globally is considered to be in extreme poverty. The theory goes that this is because non-traded goods and services, and the cost of living, tend to be cheaper in low-income rather than high-income countries. So, in countries that are labour-intensive, the real incomes and power of a currency might be several times higher than is suggested by the nominal GDP. Due to the large differences in price levels between developed and developing economies, it might not be enough to simply countries market rate converted GDP. One we add this concept onto APPP, we can see that inflation rates will account for part of the change in the power of currencies.
Relative purchasing power parity is an expansion of the traditional purchasing power parity 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. The theory of purchasing power parity relies on the idea of arbitrage – the opportunity to buy an item in one place, and sell it for higher price immediately in another, taking advantage of price differentials. This would eventually cause prices to converge, as the buying and selling would balance prices.
What is purchasing power parity?
Absolute purchasing power parity is the basic PPP theory, which states that once two currencies have been exchanged, a basket of goods should have the same value. Assume that inflation in the U.S. causes the real price of goods to increase by 4%, while it also causes the price of identical goods in Australia to increase by 2%. From the values above, we can clearly see that the U.S. has suffered more inflation because the value has moved faster than that of Australia by 2 points. Thus, the U.S. will have a negative 2 point in the exchange rate between the USD and AUD . In other words, it is expected that the USD would depreciate at a rate of 2% per annum against the AUD, or the AUD will increase at 2% per annum against the USD.
However, in reality, there are transaction costs, government taxation and barriers to trade that prevent costs from equalising. Also, purchasing power parity is a theoretical concept that may not be true in the real world, especially in the short run. Perhaps the most famous PPP index was devised by The Economist to measure how many units of a currency are needed to purchase a McDonald’s Big Mac – known as the Big Mac index. This is considered a fun-focused take on PPP but has nevertheless become extremely widely used. Once the value of a hamburger in each country is known, exchange rates can then be adjusted to show the purchasing power of each currency.
The below graph looks at the average cost of an apartment or flat in the centre of a major global city, per square metre. Using the data, we can estimate that – at the average flat size of 70 square metres – a flat in central London would cost £917,000, while a flat in central Cape Town would cost just £140,000. Following PPP theory, this would mean that over time, the Danish krone should increase by 6.6% to parity with the US dollar. The burger was chosen due to the global reach of McDonald’s, with an estimated 36,889 outlets in 120 countries. Although it’s worth noting that due to differences in ingredients, even this isn’t a perfect measure of PPP.
However, there are so many other ways that individuals and institutions can use PPP to interpret socioeconomic data. These include assessing contributions to carbon emissions, measuring global poverty and even predicting financial markets. However, if you were then to look at the market exchange rate of the GBP/USD pair, it is actually closer to 1.25.
If the PPP rate indicates a currency is over-valued compared to another, then a trader would consider going short on the currency in question. While, if the PPP rate shows the currency is under-valued against the USD, they could consider taking a long view of the market. By looking at the above charts, we can see that in 2014, GDP in PPP more accurately represents the patterns of carbon emissions in each country than GDP at the exchange rate at the time.
Relative purchasing power parity is an economic theory that states that exchange rates and inflation rates in two countries should equal out over time. Relative Purchasing Power Parity refers to the expansion of the purchasing power parity theory to involve inflation changes as time goes by. The amount of goods and services that one power of money can purchase is referred to as purchasing power. According to the RPPP, nations with higher inflations will have a lesser valued currency compared to their counterparts with lower inflation rates. Commonly called absolute purchasing power parity, this theory assumes that equilibrium in the exchange rate between two currencies will force their purchasing powers to be equal.
What is Relative Purchasing Power Parity?
RPPP also complements the theory of absolute purchasing power parity , which maintains that the exchange rate between two countries will be identical to the ratio of the price levels for those two countries. Relative PPP doesn’t hold at any one moment in time because the exchange rate is much more volatile than the average price level. However, standard economic models assume it holds in the long run—that is, when prices have had the time to adjust. Moving from the law of one price to purchasing power party is also complicated by the fact that people in different countries consume different goods. Absolute PPP doesn’t hold, as shown by the fact that PPP exchange rates normally deviate from nominal exchange rates.
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. Suppose that over the next year, inflation causes average prices for goods in the U.S. to increase by 3%. We can say that Mexico has had higher inflation than the U.S. since prices there have risen faster by three points. For instance, meat is much more expensive in Switzerland than in Italy, France, or Germany, but a person can’t legally import large quantities of meat into Switzerland without paying large import duties.
However, the theory ignores the existence of inflation and consumer spending, as well as transportation costs and tariffs, which can impact the short-term exchange rate. The economic theory of PPP is commonly used to compare the economic health of countries across the world. We take a look at the different types of purchasing power parity and how the theory applies to financial markets. Let’s say you wanted to compare the purchasing power of the US dollar and Danish krone using the Big Mac index. In January 2018, the index showed that the krone was undervalued against the dollar by 6.6% – the average Big Mac in the US was worth $5.28, while it was worth kr30 (the equivalent of $4.93).
Full BioMichael Boyle is an experienced financial professional with more than 10 years working with financial planning, derivatives, equities, fixed income, project management, and analytics.
The formula for purchasing power parity 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. A cup of coffee will have the same basic makeup regardless of where you buy it – coffee, water and milk – however the cost of each cup can vary hugely depending on where you buy it.
According to this theory, two currencies are at par when a market basket of goods is valued the same in both countries. A good starting point is the law of one price , which states that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important. Intuitively, LOP holds because, if prices were lower in country A and higher in country B, people would simply buy the lower-priced good in country A and sell it in country B at a higher price. It is important to note that using purchasing power parity is not necessarily the best strategy for short-term traders. The method does not account for short-term volatility, so it is only really useful for longer longer-term trading styles. This is why it is important for PPP to be just one part of an overall fundamental analysis strategy, and to be used alongside technical analysis indicators.
The theory is also reliant on the basket of goods being completely identical, or at best very similar goods. For a truly meaningful comparison, the basket would have to contain a wide variety of goods and services. The amount of data that has to be collected by a financial institution is huge, and it can be a complex process.
