Purchasing Power Parity (PPP) theory is based on the concept that two similar products should be valued same in two different countries considering the currency exchange rate. This theory supports the long-term equilibrium currency exchange rates in the world. Using the PPP method, the currency exchange rate can be calculated for each country.
Now local and foreign currencies are used and traded for the purpose of trade in goods and services across the countries. The import and export helps to define the exchange rate in large manner. But currency exchange rate also depends on the market interest rate, foreign fund inflow to buy capital assets or stocks or bonds, Central bank intervention, speculation trading, hedge etc. PPP method does not consider these factors while calculating the currency exchange rate as it considers only the long term effects.
Why do we need to adjust GDP based on PPP?
GDP is always calculated in US dollar term considering the current currency exchange rate. The currency exchange rate also depends on other factors which are nowhere related to the GDP or export-import data which makes the exchange rate very volatile. Volatile exchange rate can distort the actual GDP data significantly if we don’t adjust them based on the PPP exchange rate.
Let’s take an example ofIndia. SupposeIndiais having GDP of USD 100 billion during the last quarter and currency rate is Rs 50 per USD as per the normal currency exchange rate and PPP exchange rate. Now in Rupee terms the GDP will be Rs 5000 billion.
Now if the value of Indian rupee fell by 20% to Rs 60 per USD, then Indian GDP will be around USD 83 billion without any change in consumption, investment and government spending. Indian GDP will fall by 17% without any change in other GDP calculation parameters. It does not necessarily mean thanIndiabecomes poorer by huge 17% while consumption, spending and investment in local currency stays the same. To avoid this problem, GDP is adjusted based on the PPP exchange rate.