What is the Difference between exchange rate GDP and Purchasing Power Parity GDP?
This is a question that I could hear everyone thinking during our IMF visit last week. I meant to post on it sooner, but I got distracted. I hope it's still helpful.
I know that everyone is in ECON-100 (if that), so I will try to make this an easily accesible explanation!
There are various ways of calculating Gross Domestic Product (GDP), which is the total amount of goods and services produced in an economy. GDP is always calculated in some type of currency unit, and in order to compare GDP across countries the unit needs to be the same. Generally, the US Dollar is used for these transactions. However, this poses a problem because most countries have their own national currency, so the price of goods in their country is not measured in dollars. This means that the price must be converted into dollars. The two principal ways to do this are using exchange rate and purchasing power parity (PPP).
With exchange rate calculations, the value of a country's GDP is calculated using the nominal exchange rate on the currency markets. With PPP calculations, the conversion is based on how much one could buy with a given currency.
An example, because I know that was confusing:
We have two countries, A and B. 1 Country A dollar = 2 Country B pesos. The GDP of Country A is 100billion dollars and the GDP of Country B is 100 billion pesos. We would like to know the GDP of Country B in Country A dollars.
100 billion pesos x (1 dollar/2 pesos) = 50 billion pesos
However, if I tell you that a typical good that costs 1 dollar in Country A costs 1 peso in Country B, what is the GDP using PPP?
Purchasing power of 1 Country A dollar = 1 Country B peso
100 billion pesos x (1 dollar/1 peso) = 100 billion pesos
Even if you didn't follow all that, you can see that the GDP of Country B appears much larger with PPP calculations than exchange rate calculations, while Country A GDP appears much larger with exchange rate calculations. This is basically the same thing that happens in the real world and is the reason that different countries (i.e. US and India) support different ways of calculating GDP!
posted by lennearb @ 4:40 PM
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