Principles of Macroeconomics / Unit 13 MAC 1215 worked example, 60 to 90 seconds
Market Rate or PPP: Which to Use
The idea
Decide which rate a question needs. Use the market rate for anything actually converted: a payment, a tourist's budget, an exporter's receipts. Use the purchasing power parity rate for comparing living standards or output across countries, because market rates swing for financial reasons that have nothing to do with what a currency buys at home.
In practice
Suppose a fixed basket costs 100 dollars in the United States and 900 pesos in Mexico. The purchasing power parity rate is 900 divided by 100, which is 9 pesos per dollar. If the market rate is 10 pesos per dollar, converting Mexican output at the market rate makes it look smaller than a basket comparison would. Now suppose financial turmoil drives the market rate to 12 pesos per dollar within a month while Mexican prices, wages and output are unchanged. Measured at market rates, Mexican GDP in dollars has fallen sharply. Measured at parity, nothing happened, because nothing did.
Where people slip
That last case is the reason the distinction exists, and unit three met it from the other side: a steady economy can appear to shrink or grow purely because its currency moved. Neither rate is the true one. They answer different questions, and the error is using the market rate for a comparison it was never built to make.
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