What is relative PPP, and why does it represent a weaker relationship between exchange rates and prices than absolute PPP?
What will be an ideal response?
The theory of relative PPP specifies that exchange rates adjust in response to differences in inflation rates across countries to leave the deviation of the actual exchange rate from absolute PPP unchanged. Intuitively, inflation is the rate of loss of the internal purchasing power of a currency. Thus, if two currencies are losing internal purchasing power at different rates because the rates of inflation in the two countries are not equal, the rate of change of the exchange rate can offset the differential rates of inflation to leave the same absolute relationship between the internal and external purchasing powers of the currencies. The relative PPP theory is weaker than absolute PPP because relative PPP could be satisfied even though there are deviations from absolute PPP. The requirement for relative PPP to hold is that the deviations from absolute PPP do not change over time.
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What will be an ideal response?