Differentiate between Absolute and relative purchase power parity.

Absolute vs. Relative Purchase Power Parity

• Absolute Purchasing Power Parity (PPP):

  • Absolute PPP suggests that the price of a basket of goods should be the same in two different countries when measured in a common currency.
  • It implies a direct one-to-one relationship between changes in exchange rates and changes in price levels.
  • For example, if a basket of goods costs $100 in the US and ₹7500 in India, the exchange rate should be 1 USD = 75 INR for absolute PPP to hold.

• Relative Purchasing Power Parity:

  • Relative PPP focuses on the rate of change in prices between two countries. It suggests that the rate of depreciation or appreciation of a currency is equal to the difference in inflation rates between two countries.
  • This concept is more dynamic and considers inflation differentials in determining exchange rate movements.
  • For instance, if the US has an inflation rate of 2% and India has an inflation rate of 6%, the Indian Rupee should depreciate relative to the US Dollar by approximately 4% per year.

In summary, adaptive and rational expectations differ in how individuals predict future economic variables, with the former based on past trends and the latter on all available information. Absolute and relative PPP differ in their approach to comparing prices across countries, with the former comparing absolute prices and the latter focusing on the rate of change in prices and its impact on exchange rates.