Given that relative PPP
is a necessary, but not sufficient, condition for absolute PPP to hold, this study tests the relationship between the change in the log of the exchange rate, and the changes in the log of the U.S.
This requires that the exchange rate drifts in such a manner as to restore the relative PPP
. Algebraically these deviations can be expressed as:
(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.
(4.) In other words, relative PPP
requires only that changes in relative price levels be offset by changes in the nominal exchange rate.
is the long-run condition where changes in exchange rates over time are proportional to relative changes in the price levels between countries over the same period of time.
A modern variant of this theory, relative PPP
, asserts that the nominal exchange rate should depreciate when domestic inflation is higher than the rate of inflation in the foreign country.
If relative PPP
holds, the domestic industry's inflation in the traded sector T, [[Pi].sub.iT], equals the industry's world price growth in the tradeable sector, [Mathematical Expression Omitted], adjusting for percentage changes in the nominal exchange rate, E,
Two versions of PPP exist, absolute PPP and relative PPP
.(3) Under absolute PPP, the law of one price is extended to price levels and the nominal exchange rate, expressed as the domestic price of foreign currency, is related to the domestic and foreign price levels as follows..
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.