This requires that the exchange rate drifts in such a manner as to restore the relative PPP
2) See Charles Engel's Web page in note 1 for the exact definition of both absolute and relative PPP
Most studies of PPP, therefore, are based on relative PPP
, which does not require either the same basket of goods or the same weights applied to these goods in the price index.
Overvalued" can be a subjective and vague term, but economists usually adopt relative PPP
as the metric.
Because aggregate prices are reported as indices rather than levels, most empirical work has tested the weaker hypothesis of relative PPP
, which requires only that the real exchange rate be stable over time.
If relative PPP
holds, the domestic industry's inflation in the traded sector T, [[Pi].
However, to test the absolute PPP for the countries, the deficiency of the proper price level data available for internationally standardised baskets of goods and its inability' to capture the inflation differentials between countries, researchers often move to the testing of relative PPP
The absolute version of PPP (APPP) posits a long-run relation between the bilateral exchange rate and price levels of two relevant countries, while relative PPP
(RPPP) suggests comovements of changes in the exchange rate with the inflation differential of two countries.
A less stringent, but more realistic relation is relative PPP
10) In contrast, relative PPP
refers to the relationship between relative change in nominal exchange rate and the differential in relative changes in price levels, that is, [DELTA]s/s = [DELTA]p/p - [DELTA]p/[p.
Deviations from relative PPP
imply movements in the real exchange rate.
More appropriately, relative PPP
can be expressed as [Delta]ln(e) = [Delta]ln([P.