Compare and contrast the absolute and relative versions of the principle of purchasing power parity (PPP) and evaluate the practical usefulness of the principle.Definition of purchasing power parity purchasing powerPPP is an economic theory which states that the price of common goods between two different countries being compared should be equal when converted into a common currency. The PPP ratio presents two identical countries for products or a group of products, a relative difference in price level. The basis of the PPP is the “law of one price”. The law of one price simply states that in the presence of a competitive market structure and the absence of transportation costs and other barriers to trade, identical products sold in different markets will sell. at the same price when expressed in terms of a common currency (Keith Pilbeam, fourth edition, p. 126). The law is mathematically expressed as follows: PAFN = E x PRs In the above formula, PAFN is the price of the product in Afghani, PRS is the price of the product is in Pakistani rupees and E is the exchange rate between rupees Afghan and Pakistani. For example, if the price of an identical TV in Afghanistan is 1,000 AFN and it costs 2,000 rupees in Pakistan, then according to the law of prices the exchange rate should be 0.5 and if the rate exchange rate was higher i.e. 0.6 then Pakistani trader will start buying TV in Afghanistan and trade it in Pakistan since arbitrage profit opportunity arises and traders will continue to make profit by selling Pakistani rupees and buying Afghans who show up. an increase in demand for Afghani and leads to a depreciation of the Pakistani rupee, this will continue until such time as arbitrage profit opportunities are eliminated, market forces, demand and supply take hold and prices will balance...... middle of paper ... ...omic events that are sudden and cause a relative change in the price level. Studies have shown that relative PPP holds up better in the long term than in the short term. General studies persist that PPP is not an exchange rate theory since the exchange rate varies depending on other factors. than the price. Price and exchange rate are endogenous variables. Purchasing power parity used in three concepts to explain identical goods should cost the same in two different countries when converted to a common currency. The law of one price relates the exchange rate to the price of individual goods. Absolute PPP relates the exchange rate to the general price level and relative PPP relates the exchange rate to the inflation rate.ReferenceAuthor's NAME, INITIALS., Year of publication. Title. Edition (if not the first). Place of publication: Publisher. Reference to web pages/sites and e-books/e-journals