A form of purchasing power parity (PPP) that, contrary to the absolute purchasing power parity, takes market imperfections into account, especially changes in relative prices due to differences in tastes and preferences across countries, changes in the relative prices of traded and non-traded goods from one country to another, and the varying effects of equilibrium changes in the relative prices of goods across countries in a way that involves the balance of payment.
Because of these factors, consumption bundles vary from one country to another. However, the relative PPP states that exchange rates adjust in response to variations in inflation rates across countries such that differences in purchasing power are preserved. This implies an economic fact that inflation reduces purchasing power of money. Therefore, if the inflation rates of two countries are 6% and 3%, then a depreciation of the high-inflation currency to the low-inflation currency would be required to make the loss of the latter’s external purchasing power equal to the loss of its internal purchasing power.
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