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PPPs and Exchange Rates

To make international volume comparisons of GDP, the GDPs of countries have to be expressed in the same currency unit and valued at the same price level. Once this is done, the differences between the GDPs will reflect only differences in the volumes of goods and services produced. Therefore, as the GDPs of countries are in national currencies and at national price levels, it is first necessary to convert them to a common currency and revalue them at a uniform price level before making volume comparisons. The ICP uses PPPs to do this because PPPs are both currency converters and spatial price deflators. In other words, they are conversion rates that both convert to a common currency and equalize the purchasing power of different currencies in the process of conversion.

 

Before PPPs became available, exchange rates were used to make international comparisons of GDP and there are analysts who argue that they should still be used. Exchange rates, however, only convert the GDPs to a common currency, they do not provide GDPs valued at a uniform price level. This is because exchange rates do not reflect the relative purchasing powers of currencies in their national markets. At most, they could only do so for goods and services that are internationally traded, but many goods and services, such as buildings, government services and most market services, are not traded internationally. Moreover, the supply and demand for different currencies that determine exchange rates are influenced more by factors such as currency speculation, interest rates, government intervention and capital flows between countries than by the currency requirements of international trade. Consequently, the GDPs of countries converted to a common currency with exchange rates remain valued at national price levels. Differences between them reflect not only differences in the volumes produced in the countries but also differences in the price levels of countries.

 

Although the ICP does not use exchange rates for volume comparisons, it does use them for price comparisons. Price level indices are computed as the ratios of PPPs to exchange rates. See Price and volume measures. Exchange rates are also used as proxy PPPs for net purchases abroad and for net exports of goods and services when calculating the PPPs for GDP.