 The second form of purchasing power parity is known as relative purchasing power parity. The relative purchasing power parity phenomena tells us that what determines the change in the exchange rate over a period of time. To understand the basic idea behind the working of relative purchasing power parity let's take an example. We assume a spot exchange rate between Great Britain Pound and US Dollar at 0.50 Pound. Next year's inflation is expected to be 10% in Britain and 5% in US. If this is the case then what will be next year's exchange rate? So that is the question. We see that Dollar is currently selling at 0.5 Pound in Britain and inflation will rise prices in Great Britain by 10% So the Dollar's value will also be increased by this percentage to the tune of 0.55 Pound. If the inflation rate in US is at 0 then we need to worry about the relative inflation rates in both of the countries like US and UK. Now we assume that there is a 4% inflation rate in the US economy. This means that relative to the prices in US, prices in the UK will be increased by 6% and 6% is basically the difference between inflation rate in US and the inflation rate in UK. So this 6% is the difference between 10% and 4%. Now if we grow the value of Dollar at this 6% this will come to 0.5 Pound. So what is the result? You see that the relative purchasing power parity says that changes in the exchange rate is determined by differences in the inflation rate of the two countries and that we have seen earlier. Let's see another example. We assume that S not is equal to the current spot exchange rate for US Dollar and EST refers to the expected exchange rate in T time periods and H US is the inflation rate in US whereas H UK refers to the inflation rate in UK. So using these notions relative purchasing power parity says that the expected percentage change in exchange rate over the period is equal to the differences in the inflation rate and if we put this statement into an equation form we see the equation has two sides. The left side refers to the percentage change increase in the exchange rate whereas the right side of the equation refers to the difference in the inflation rates of the two countries. If we rearrange this equation this equation can be read as that the expected change in the exchange rate is equal to the spot exchange rate grown at the differential inflation in the two countries. Now to understand this equation we have an example where we see that relative purchasing power parity allows an exchange rate to grow by 6% which is a difference between 10% inflation rate in UK and 4% inflation rate in US economies. Now assuming there is no change in the inflation rates so the expected changes in the exchange rate in the next two years will be equal to 0.562 and that 0.562 is basically the product of the expected spot rate grown by the inflation rate over the next two years. In general we can see that relative purchasing power parity says that the expected exchange rate is basically at some time equal to the spot exchange rate multiplied by the differential inflation rate compounded at the difference of inflation between the two countries. We have another example whereas we see that current exchange rate between Japanese yen and US dollar is 0.105 Japanese yen per US dollar. The expected inflation rate over the next three years is predicted to be 2% in Japan and 6% in US and based on relative purchasing power parity what will be the exchange rate in the next three years. To solve this puzzle we see that the higher inflation in the US will lower the value of the dollar in other economies. So the exchange rate will be now negative 4% and that negative 4% is due to the difference between 2% inflation rate in Japan and 6% inflation rate in the US and when we grow our spot exchange rate for three years at this negative inflation rate the expected exchange rate comes to 92.90 Japanese yen. There is a difference between currency appreciation and currency depreciation. Currency appreciation refers to the requirement of more units of foreign currency to buy one unit of domestic currency. For example, movement in exchange rate between Euro and US dollar from 1.10 to 1.15 means that Euro has appreciated by 0.05 US dollar against the dollars. Currency depreciation is opposite to the currency appreciation. This means that requiring a lesser unit of foreign currency to buy one unit of domestic currency. For example, movement in exchange rate between Euro and US dollars from 1.10 to 1.05 means that Euro has depreciated by 0.05 against the US dollar.