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Q. Explain why Relative PPP is useful when comparing countries that base their price levels on different product baskets.
Answer: For instance If the U.S price level increase by 10% over a year while Europe's rises by only 5% relative Purchasing Power Parity (PPP) predicts a 5% depreciation of the dollar against the euro. This now cancels the 5% by which U.S inflation surpass European leaving the relative domestic and foreign purchasing powers of both currencies unchanged.
(E$/E,t - E$/E,t-1)/E $/E,t-1 = _US,t - _E,t among dates t and t - 1.
Relative Purchasing Power Parity (PPP) is useful when comparing countries that base their price levels on different product baskets. Relative Purchasing Power Parity (PPP) may be valid even when absolute PPP is not.
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