What is the difference between absolute and relative purchasing power parity, and does PPP actually hold in practice?

Purchasing Power Parity (PPP) is one of the foundational exchange rate theories tested on CFA Level II. Let's clarify both versions.

Absolute PPP:

States that the exchange rate between two currencies should equal the ratio of price levels in the two countries.

S(d/f) = P_domestic / P_foreign

For example, if a basket of goods costs $150 in the US and EUR 120 in Germany:

S(USD/EUR) = 150 / 120 = 1.25 USD per EUR

This rarely holds because:

• Transportation costs and tariffs prevent perfect arbitrage
• Not all goods are tradeable (haircuts, real estate)
• Quality differences across countries
• Tax structures differ

Relative PPP:

A weaker but more useful version. It states that the change in the exchange rate should equal the difference in inflation rates:

%DS(d/f) approximately = inflation_domestic - inflation_foreign

If US inflation is 3% and German inflation is 1%, relative PPP predicts the USD should depreciate by about 2% against the EUR.

Worked Example:

Current spot rate: 1.10 USD/EUR

US expected inflation: 4.5%

Eurozone expected inflation: 2.0%

PPP-implied 1-year spot rate:

S1 = 1.10 x (1.045 / 1.020) = 1.10 x 1.0245 = 1.127 USD/EUR

The dollar is expected to weaken because higher US inflation erodes its purchasing power.

Why Short-Term Deviations Occur:

1. Capital flows — Investment flows driven by interest rates, growth expectations, and risk appetite dominate trade flows in the short run
2. Sticky prices — Goods prices adjust slowly while exchange rates adjust instantly
3. Non-traded goods — Services (which make up 60-70% of developed economies) don't arbitrage across borders
4. Speculation — Currency markets can overshoot based on momentum and positioning

The Real Exchange Rate:

When PPP doesn't hold, the real exchange rate deviates from equilibrium:

q = S x (P_foreign / P_domestic)

If q > 1, the domestic currency is undervalued in real terms (goods are cheap domestically). If q < 1, the domestic currency is overvalued.

Exam tip: CFA Level II frequently tests whether a currency is overvalued or undervalued relative to PPP. Calculate the PPP-implied rate and compare it to the actual spot rate. Also remember that PPP works better for high-inflation environments and long time horizons.

For more international economics content, explore our CFA Level II course on AcadiFi.