1. Absolute purchasing power parity: refers to the equilibrium exchange rate between domestic currency and foreign currency equal to the ratio of purchasing power or price level between domestic currency and foreign currency. Absolute purchasing power parity holds that the value and demand of a country's currency are determined by the quantity of goods and services that a unit currency can buy at home, that is, by its purchasing power, so the exchange rate between the two currencies can be expressed as the ratio of purchasing power of the two currencies. Purchasing power is reflected by the price level. According to this relationship, the rise of domestic prices will mean the depreciation of local currency relative to foreign currency. Relative purchasing power parity makes up for some shortcomings of absolute purchasing power parity. The main point can be simply stated as follows: the exchange rate level of the two countries' currencies will be adjusted according to the difference of inflation rates between the two countries. It shows that the relative inflation of the two countries determines the equilibrium exchange rate of the two currencies. Generally speaking, the purchasing power parity theory reasonably explains the determination basis of exchange rate. Although it ignores the influence of international capital flow and other factors on exchange rate, it is still valued by western economists and widely used in mathematical models for forecasting exchange rate trends in basic analysis.
Absolute purchasing power parity is an early purchasing power parity theory. Absolute purchasing power parity means that at a certain point in time, the exchange rate of two currencies is determined by the purchasing power ratio of the two currencies. If the reciprocal of the general price index is used to express the purchasing power of their respective currencies, then the exchange rate between the two countries is determined by the ratio of the general price levels of the two countries. With the exchange rate under direct quotation, Pa and Pb respectively represent the absolute level of general prices at home and abroad, so the absolute purchasing power parity formula is:
Ra=Pa/Pb or Pb=Pa/RaRa: indicates the exchange rate of local currency against foreign currency.
Pa stands for domestic price index Pb stands for foreign price index. It explains the determination of the exchange rate at a certain point, and the main factor that determines the exchange rate is the purchasing power of the currency or the price level.
2. Relative purchasing power parity: refers to the relative change between the purchasing power of currencies in different countries and is the decisive factor of exchange rate changes. It is believed that the main factor of exchange rate change is the relative change of currency purchasing power or price between different countries; Compared with the period when the exchange rate is in equilibrium, when the purchasing power ratio of the two countries changes. Then the exchange rate between the two currencies must be adjusted.
Relative purchasing power parity (PPP) represents the change of exchange rate over a period of time, in which inflation is taken into account. 19 18 after the end of the first world war, economists revised the absolute purchasing power parity because of the indiscriminate issuance of bank notes by countries during the war, inflation and rising prices. They believe that the exchange rate should reflect the relative changes in the price levels of the two countries, because inflation will reduce the purchasing power of currencies in different countries to varying degrees. Therefore, when inflation occurs in both currencies, their nominal exchange rates are equal to the quotient of their past exchange rates multiplied by the inflation rates of the two countries. That is, relative purchasing power parity indicates the change of exchange rate in a certain period, that is, the ratio of exchange rate at two time points is equal to the ratio of general price index of the two countries. E0 and et are used to represent the exchange rate in the base period and the exchange rate in the reporting period respectively, and Pld and Plf are used to represent the general price index at home and abroad in the reporting period respectively, so the relative purchasing power parity formula is:
Rate of change in purchasing power of domestic currency
New exchange rate in functional currency = old exchange rate in functional currency × change rate of foreign currency purchasing power
Domestic price index
= Old exchange rate of domestic currency × foreign price index
3. The relationship between absolute purchasing power parity and relative purchasing power parity.
If absolute purchasing power parity is established, relative purchasing power parity must also be established, because the price index is the ratio of absolute prices at two time points. Conversely, if relative purchasing power parity is established, absolute purchasing power parity may not be established. For example, the exchange rate in the base period and the reporting period is equal to half of absolute purchasing power parity, and then the relative purchasing power parity is established, and the absolute purchasing power parity is not established.