# Understanding Relative Purchasing Power Parity (RPPP) and Its Impact on Currency

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## What Is Relative Purchasing Power Parity (RPPP)?

Relative purchasing power parity (RPPP) is an expansion of the traditional [purchasing power parity](https://www.investopedia.com/updates/purchasing-power-parity-ppp/) (PPP) theory that includes changes in [inflation](https://www.investopedia.com/terms/i/inflation.asp) over time and connects differences in inflation to changes in exchange rates. RPPP has certain limitations, such as assumptions of perfect competition, homogeneous goods, and exclusion of non-tradable goods and transportation costs. Practical applications of RPPP can be impeded by market sentiment, speculative trading, and insufficient data.

### Key Takeaways

*   Relative Purchasing Power Parity (RPPP) explains that disparities in inflation rates between two countries can proportionally affect their exchange rates, impacting overall purchasing power.
*   The theory is an extension of absolute purchasing power parity (APPP) and considers inflation rate changes over time, unlike APPP which assumes static price levels.
*   While RPPP provides a theoretical framework for understanding exchange rate adjustments, it faces practical limitations, including assumptions of perfect competition, homogeneous goods, and exclusion of non-tradable goods and transportation costs.
*   RPPP suggests that countries with higher inflation rates will likely experience a depreciation in currency value to maintain equilibrium in international trade.
*   Although RPPP is a widely discussed economic theory, real-world applications can be challenged by factors like market sentiment, speculative trading, and data limitations.

## How Inflation Differences Affect Exchange Rates under RPPP

According to RPPP, differences in inflation rates and commodity costs between two countries drive changes in their [exchange rate](https://www.investopedia.com/terms/e/exchangerate.asp).​​​​​​​

RPPP expands on the idea of purchasing power parity and complements the theory of absolute purchasing power parity (APPP). The APPP concept declares that the exchange rate between the two nations will be equal to the ratio of the price levels for those two countries, and APPP is discussed later in this article.

## Theoretical Foundations of Purchasing Power Parity

Purchasing power parity (PPP) is the idea that goods in one country will cost the same in another country, once their exchange rate is applied. According to this theory, two [currencies](https://www.investopedia.com/terms/c/currency.asp) are at par when a market basket of goods is valued the same in both countries.

Comparing prices of identical items in different countries determines the PPP rate, but exact comparison is tough due to product quality, consumer attitudes, and economic conditions. Also, purchasing power parity is a theoretical concept that may not be true in the real world, especially in the short run.

> **Fast Fact**
>
> In 2023, the purchasing power index of the United States is 115.75.

## The Dynamic Interplay of Inflation and Exchange Rates in RPPP

RPPP is a dynamic form of PPP, linking changes in two countries' inflation rates to changes in their exchange rate. The theory holds that inflation will reduce the real [purchasing power](https://www.investopedia.com/terms/p/purchasingpower.asp) of a nation's currency. If a country's annual inflation rate is 10%, its currency can purchase 10% fewer real goods after one year.

RPPP also complements the theory of absolute purchasing power parity (APPP), which maintains that the exchange rate between two countries will be identical to the ratio of the price levels for those two countries.

This concept comes from a basic idea known as the [law of one price](https://www.investopedia.com/terms/l/law-one-price.asp). This theory states that the real cost of a good must be the same across all countries after the consideration of the exchange rate.

## Practical Example of Relative Purchasing Power Parity

Suppose that over the next year, inflation causes average prices for goods in the U.S. to increase by 3%. In the same period, prices for products in Mexico increased by 6%. We can say that Mexico has had higher inflation than the U.S. since prices there have risen faster by three points.

According to RPPP, the three-point inflation difference will cause a three-point change in the U.S.-Mexico exchange rate. So we can expect the Mexican peso to [depreciate](https://www.investopedia.com/terms/c/currency-depreciation.asp) at the rate of 3% per year, or that the U.S. dollar should appreciate at the rate of 3% per year.

## Key Challenges and Limitations of Applying RPPP

Users of RPPP information must be mindful of several limitations in the inherent process of calculating RPPP. Some of the limitations include:

*   **Inaccurate Assumption of Perfect Competition.** RPPP assumes perfect competition in all markets, which often isn't true in reality. Imperfect competition, market distortions, and barriers to trade can lead to deviations from RPPP.
*   **Inaccurate Assumptions that Goods Are Homogeneous.** RPPP assumes that goods and services are identical across countries, which is rarely true in reality. Differences in product quality, branding, and consumer preferences can affect price levels.
*   **Excluded Transport Costs and Trade Barriers:** RPPP doesn't account for transportation costs or trade barriers, which can affect prices and cause deviations from parity.
*   **Not All Goods Are Tradeable:** RPPP focuses on tradable goods and services, but many items are not easily traded across borders (e.g., housing, local services). These non-traded goods can create disparities in price levels.
*   **Limited Data and Timing:** Accurate and timely data on price levels can be challenging to obtain, especially in developing countries, making it difficult to apply RPPP accurately.

> **Important**
>
> Exchange rates are also influenced by trading and market sentiment, leading to possible deviations from RPPP predictions.

## Comparing Relative and Absolute Purchasing Power Parity

There's a couple of differences between relative purchasing power parity and absolute purchasing power parity (APPP). First, PPP is primarily concerned with comparing the relative price levels of two or more countries to determine their exchange rates. Absolute PPP is a simpler concept that focuses on the absolute price levels within a single country.

Second, PPP suggests that exchange rates should adjust over time to equalize the purchasing power of currencies, allowing for a more accurate representation of the real exchange rate. APPP implies that exchange rates should be fixed or constant based on the ratio of absolute price levels between two countries.

Last, PPP takes into account changes in price levels over time while APPP does not. Because APP assumes that exchange rates should always be at a constant ratio, it does not account for inflation.  

## What Is the Formula for Purchasing Power Parity?

The formula for purchasing power parity (PPP) 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.

## What Country Has the Highest Purchasing Power?

According to the crowdsourced database Numbeo, Luxembourg has the highest purchasing power with a purchasing power index number of 127.1 in 2023. Other top countries include Qatar (123.6), United Arab Emirates (123.4), and Switzerland (118.7). The lowest country in 2023 is Nigeria (8.4).

## Why Is Purchasing Power Parity Important?

Purchasing power parity is important because it allows economists to [compare two different economies](https://www.investopedia.com/articles/fundamental-analysis/ppp-big-mac.asp), primarily the economic productivity and the standard of living among nations. It seeks to equalize currencies to determine the value of a basket of goods.

## The Bottom Line

Relative purchasing power parity is an economic theory that suggests exchange rates between two countries' currencies should adjust over time to reflect differences in their price levels. According to RPPP, if one country experiences higher inflation than another, its currency should depreciate to maintain the same purchasing power across borders, promoting equilibrium in international trade. While RPPP is useful for understanding macroeconomic trends, its practical application can be limited due to factors like market imperfections, non-tradable goods, and trade barriers.

> **Article Sources**
>
> 1.  Numbeo. "[Purchasing Power Index by Country 2023](https://www.numbeo.com/quality-of-life/rankings_by_country.jsp?title=2023&displayColumn=1)."