Relative purchasing power parity

The relative purchasing power parity theory (RPPPT) does not predict that price levels are the same across countries. It predicts that the changes in price levels are the same across countries.

For example, when we look at most goods and services, Switzerland is about 40% more expansive than the U.S. Prices in the two countries will probably be different for some time to come. However, the RPPPT predicts that the changes in prices in the two countries will be the same.

That happens in two ways. First, the U.S. and Switzerland could have the same inflation rate. If the U.S. inflation rate is 5% per year and the Swiss inflation rate is 5% per year, then prices will be increasing by 5% in both countries. Switzerland will still be 40% more expensive than the U.S. but the prices would be changing at the same rate.

Second, inflation rates could be different but the exchange rate may change. For example, U.S. inflation could be 5% and the Swiss inflation could be 0%. However, the Swiss Franc could appreciate (become more expensive) against the dollar by 5%. That could automatically make Switzerland 5% more expensive in dollar terms.

The RPPPT holds better than the absolute purchasing power parity theory. Still, it takes several years until inflation rates and exchange rates adjust as described above. Don’t expect the theory to give you correct predictions over a year or two.


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