Why do economists distinguish between absolute and relative PPP?
[Mathematical Expression Omitted] where: s is the exchange rate; p is the domestic price level; and [p.sup.*] is the foreign price level (all measured in natural logarithms). The distinction is made on the basis of whether the relationship holds at a particular point in time (absolute) or between two points in time (relative). On the theoretical side, the distinction between absolute and relative PPP was first mentioned and attributed to Cassel by Pigou [QJE, November 1922]. It can be demonstrated that this distinction is empirically redundant, theoretically useless, and only emerged out of the misinterpretation of Cassel. First, since data on aggregate price levels are not available, economists have to use price indices to test PPP. Since price indices measure price levels relative to a base period, using (1) must amount to testing relative PPP. Thus, (1) and (2) represent relative PPP in levels and first differences, respectively. If the variables underlying (1) are cointegrated, the
