How to calculate relative purchasing power parity

Written by pedro carrasquillo
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How to calculate relative purchasing power parity
National currencies have different purchasing powers. ( Images)

Relative purchasing power parity is an economic theory that describes the relationship between two different currencies over time. As the prospects for economic activity vary across countries through the business cycle, so will the relative strength of the world's currencies. Relative purchasing power captures this relative relationship by comparing the rate of change in price levels that contribute to inflation. Calculating the relative purchasing power parity between two different currencies makes it possible to evaluate over time whether a country's currency increased or decreased in value relative to another country's currency, or if the currencies achieved parity.

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  1. 1

    Identify the two currencies you want for your calculation of the relative purchasing power parity relationship. Due to some of the complexity associated with doing the calculation, you may want to try to compare the currencies of countries that have similar economic characteristics, such as free markets, a democratic form of government, a functional central banking system and free trade. Use resources such as the "U.S. CIA World Fact Book" or the World Bank for researching the currencies you intend to use in the calculation. For example, the U.S. Dollar could be compared to the European Union's Euro. Comparing the U.S. Dollar to the Sudanese Pound, however, introduces more problems for the calculation, since the economies of the two countries are very different.

  2. 2

    Identify the rate of inflation in both countries whose currencies you will be evaluating. Be sure the rates of inflation you are using correspond to the same time period. Do not try to compare rates of inflation that correspond to different periods. For example, if the British government released an inflation figure for the most recent business quarter, you would not want to compare that figure against last year's inflation number for the European Eurozone. If you are not sure which inflation figures to use, consider using the annual inflation figures published by the governments that issued the currencies you are trying to compare.

  3. 3

    Calculate the quotient of the two country's inflation rates to arrive at the relative purchasing power parity relationship. For example, if the annual rate of inflation in the Eurozone is 2 per cent and the annual rate of inflation in the U.S. is 1 per cent, the calculation is as follows: Divide the U.S. inflation rate of 1.01 by the eurozone's euro inflation rate of 1.02 to arrive at .9902 (1.01 / 1.02). (The addition of a numeral 1 to the U.S. inflation rate and the Eurozone rate is to account for the fact that you are measuring growth over a specific time period, such as one year in this case.)

    Stated another way, there is a 1 per cent differential (.9902 rounded up to 1 per cent) between the relative purchasing power for these two currencies. In this example, the U.S. Dollar's relative purchasing power increased by 1 per cent relative to the Euro, while the Euro's relative purchasing power decreased by 1 per cent relative to the Dollar.

Tips and warnings

  • Compare your relative purchasing power parity calculation against a broader measurement such as the Big Mac Index that is published by "The Economist."
  • Relative purchasing power parity is not an exact calculation for capturing the relative purchasing power of two currencies.

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