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I understand the implications of having a higher/lower GDP at market exchange rates. I also understand what PPP measures.

But, what does a difference in GDP, at PPP, indicate in terms of differences in levels?

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I like this explanation from Callen (2007), published in the IMF's F&D, their quarterly magazine. For measuring consumption in a country, PPP is probably the way to go, but international economic and financial power is probably better measured with market rates.

PPP versus market rates

So which method is better? The appropriate way to aggregate economic data across countries depends on the issue being considered. Market exchange rates are the logical choice when financial flows are involved. For example, the current account balance represents a flow of financial resources across countries. It is appropriate to use the market exchange rate to convert these flows into dollars when aggregating across regions or calculating the global current account discrepancy. But for other variables, the decision is less clear cut. Take real GDP growth. International organizations use different approaches. The World Bank uses market-based rates to determine the weights in its regional and global aggregations of real GDP, whereas the IMF and the Organization for Economic Cooperation and Development use weights based on PPP rates (although the IMF also publishes a global growth aggregate based on market rates in the WEO). Each methodology has its advantages and disadvantages.

Advantages of PPP
A main one is that PPP exchange rates are relatively stable over time. By contrast, market rates are more volatile, and using them could produce quite large swings in aggregate measures of growth even when growth rates in individual countries are stable. Another drawback of market-based rates is that they are relevant only for internationally traded goods. Nontraded goods and services tend to be cheaper in low-income than in high-income countries. A haircut in New York is more expensive than in Lima; the price of a taxi ride of the same distance is higher in Paris than in Tunis; and a ticket to a cricket game costs more in London than in Lahore. Indeed, because wages tend to be lower in poorer countries, and services are often relatively labor intensive, the price of a haircut in Lima is likely to be cheaper than in New York even when the cost of making tradable goods, such as machinery, is the same in both countries. Any analysis that fails to take into account these differences in the prices of nontraded goods across countries will underestimate the purchasing power of consumers in emerging market and developing countries and, consequently, their overall welfare. For this reason, PPP is generally regarded as a better measure of overall well-being.

Drawbacks of PPP

The biggest one is that PPP is harder to measure than market-based rates. The ICP is a huge statistical undertaking, and new price comparisons are available only at infrequent intervals. Methodological questions have also been raised about earlier surveys. In between survey dates, the PPP rates have to be estimated, which can introduce inaccuracies into the measurement. Also, the ICP does not cover all countries, which means that data for missing countries have to be estimated.

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  • $\begingroup$ Thanks. So would you say the GDP at PPP quantifies the value (or level) of a country's material well-being (as proxied by consumption)? $\endgroup$ – StatsScared Aug 20 '18 at 19:22

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