the expenditures of all economies on the same price level. Prices are easier to observe than quantities, and direct measures of relative prices usually have a smaller variability than direct measures of relative quantities. In ICP comparisons, volumes (referred to as real expenditures) are mostly estimated indirectly using direct measures of relative prices—purchasing power parities (PPPs)—to deflate nominal expenditures. In addition to being spatial price deflators, PPPs are currency converters. Thus PPP-deflated expenditures are expressed in a common currency unit and are also valued at the same price level.
Market exchange rates Before PPPs became widely available, market exchange rates were used to make international comparisons of GDP. Market exchange rates, however, only convert GDP to a common currency. They do not provide GDP valued at a common price level because market exchange rates do not reflect the relative purchasing power of currencies in their national markets. For them to do so, all goods and services would
Box 3.1
have to be traded internationally, and the supply and demand for currencies would have to be driven predominantly, if not solely, by the currency requirements of international trade. But this is not the case. Many goods and services— such as buildings, government services, and most household market services—are not traded internationally, and the supply and demand for currencies are influenced primarily by factors such as currency speculation, interest rates, government intervention, and capital flows between economies. Consequently, as equation (B3.1.2) in box 3.1 indicates, GDP converted to a common currency using market exchange rates remains valued at national price levels. The differences between the levels of GDP in two or more economies reflect both differences in the volumes of goods and services produced by the economies and differences in the price levels of the economies. However, as equation (B3.1.4) in box 3.1 shows, GDP converted with PPPs reflect only differences in the volumes produced by the economies. Market exchange rate–converted GDP— that is, nominal GDP converted to a common
Using market exchange rates and PPPs to convert to a common currency
1. The ratio of the GDPs of two economies when both are valued at national price levels and expressed in local currency units has three component ratios: GDP ratio = price level ratio × volume ratio × currency ratio.
(B3.1.1)
2. When converting the GDP ratio in equation (B3.1.1) to a common currency using the market exchange rate, the resulting GDPXR ratio has two component ratios: GDPXR ratio = price level ratio × volume ratio.
(B3.1.2)
The GDP ratio in equation (B3.1.2) is expressed in a common currency, but it reflects both the price level differences and the volume differences between the two economies. 3. A PPP is defined as a spatial price deflator and currency converter. It is composed of two component ratios: PPP = price level ratio × currency ratio.
(B3.1.3)
4. When a PPP is used, the GDP ratio in equation (B3.1.1) is divided by equation (B3.1.3), and the resulting GDPPPP ratio has only one component ratio: GDPPPP ratio = volume ratio.
(B3.1.4)
The GDP ratio in equation (B3.1.4) is expressed in a common currency, is valued at a common price level, and reflects only differences in volume between the two economies.
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Purchasing Power Parities and the Size of World Economies