What's the difference between absolute and relative purchasing power parity?

Question

AcadiFi · Accepted Answer

Absolute PPP states that the exchange rate equals the ratio of price levels: S = P_domestic / P_foreign. A Big Mac costing $5.80 in the US and 580 yen in Japan implies S = 100 yen/USD. Absolute PPP rarely holds because of transport costs, tariffs, non-tradables (haircuts, real estate), and differing consumption baskets.

Relative PPP is weaker and more empirically supported. It states that the rate of change of the exchange rate equals the inflation differential: (S_new - S_old)/S_old = pi_domestic - pi_foreign. If US inflation is 3.2% and Japan's is 0.8%, the yen should appreciate about 2.4% annually against the dollar.

Gentian Global Macro uses relative PPP as a long-run anchor for currency valuation. Short run (under 3 years), exchange rates deviate wildly from PPP due to capital flows, monetary policy, and risk premia. Over 10-20 years, currencies revert toward relative PPP benchmarks, supporting its use in strategic asset allocation but not tactical trading.

```mermaid
flowchart LR
  Abs[Absolute PPP] --> Levels[Price Levels Match]
  Rel[Relative PPP] --> Infl[Inflation Differential]
  Infl --> Long[Long Run Anchor]
  Levels --> Fail[Often Fails]
  Long --> Rev[Mean Reversion 10-20yr]
```

What's the difference between absolute and relative purchasing power parity?

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