What it means
Imagine two countries trading with each other. If prices rise 3% a year in one and only 1% in the other, the first country's goods become steadily more expensive for foreigners.
Relative PPP says the exchange rate should adjust to offset that gap, so the first currency loses value by about two percentage points a year. This differs from absolute PPP, which says a basket of goods should cost the same everywhere once converted at the exchange rate.
Relative PPP is more forgiving, because it only claims that changes in the rate follow changes in price levels. It still works if goods start out cheaper in one country, for example because of transport costs or local taxes.
Finance teams use relative PPP for long-term forecasting, particularly when a company has overseas subsidiaries or foreign-currency contracts running for several years. It supplies a reasoned starting point for budgeting future exchange rates when forward markets do not extend far enough.
Treasury teams also use it to judge whether a currency looks stretched compared with its inflation history. In practice, relative PPP holds loosely over many years and badly over a few months.
Interest rates, capital flows, political news and market mood move currencies far more than prices do in the short run. Trade barriers, non-tradable services and sticky prices also stop the adjustment from being complete.
The key skill is to use it as a direction-setting tool rather than a precise predictor. If one country has run much higher inflation than its trading partners for years and its currency has not weakened, that is a warning that a correction could eventually come.
It is a prompt to ask questions, not a trading signal on its own.
In practice
Real-world examples.
Example
A US furniture importer signs a five-year supply contract priced in euros. The finance director builds her budget using relative PPP, assuming the euro will gradually strengthen because US inflation is forecast to be higher. She adds a modest annual currency cost to the margin forecast instead of using today's rate for all five years.
Example
A manufacturer with a plant in a high-inflation country compares its subsidiary's profit in local currency with its dollar reporting results. Local profits are growing 25% a year, but relative PPP suggests the local currency will weaken by a similar amount. The group controller reminds the board that growth in local currency overstates growth in dollars.
Example
A treasury analyst at an airline reviews a currency that has not moved for three years even though local inflation has been well above its trading partners'. Relative PPP implies the currency is overvalued, so she recommends hedging revenue earned in that currency more heavily. The suggestion comes from the inflation gap, not from a market prediction.
Formula
Calculation
Expected future spot rate = Current spot rate x (1 + home inflation) / (1 + foreign inflation)
Suppose the euro currently trades at $1.10 per euro. Expected annual inflation is 3% in the United States (home) and 1% in the euro area (foreign). Expected spot rate in one year = 1.10 x 1.03 / 1.01 = 1.133 / 1.01 = $1.1218 per euro (rounded). The euro is expected to rise by about 1.98% against the dollar, which is 1.1218 / 1.10 - 1, because the dollar is losing purchasing power faster.Case study
Seen in the real world.
Brightwater Foods is an illustrative, fictional exporter that sells packaged snacks from a plant in a country with steady 6% inflation to retailers in a country with 2% inflation. For three years the exporter kept its prices in the buyer's currency unchanged and watched its margins shrink, because its local costs kept rising.
The finance manager applied relative PPP to the figures. With a 4% annual inflation gap, she expected the exporter's home currency to weaken by roughly 4% a year, which should have helped its competitiveness, but the currency had been held stable by high interest rates.
She concluded that the exporter's cost base was growing faster than any exchange-rate relief would arrive. Brightwater raised its overseas prices by 3% and added a currency clause to new contracts, and the illustrative lesson was that waiting for PPP to fix margins is a risky plan.
Watch out
Common mistakes.
- Treating relative PPP as a short-term forecasting tool, when it is only a rough guide over several years.
- Confusing relative PPP with absolute PPP, which compares price levels rather than changes in prices.
- Using the inflation gap in the wrong direction, so that the higher-inflation currency is forecast to strengthen instead of weaken.
Questions
People also ask.
Why does relative PPP often fail in practice?
Interest rates, capital flows, politics and sticky prices all move exchange rates more than inflation does in the short run, so the adjustment is slow and uneven.
Can I use relative PPP to set a budget exchange rate?
Yes, it is a reasonable starting point for multi-year budgets, but treasury teams usually compare it with forward rates and hedge the near-term exposure.
Which inflation measure should I use?
Most analysts use consumer price inflation for both countries, but whichever measure you pick, use the same one for both so the comparison is fair.
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