nontradable goods and services in developing countries are much cheaper than in developed countries.
In 1997, U.S. per capita GDP was $29,326. Switzerland's per capita GDP was $35,879 calculated using market exchange rates, but only $25,902 using PPP exchange rates. The market exchange rate for Swiss francs was about 1.45 francs per dollar, but the PPP exchange rate was about two francs per dollar because the cost of living was so high in Switzerland in Switzerland two francs were needed to buy what in the U.S. would cost a dollar, but when a tourist exchanged dollars for francs she received only 1.45 francs per dollar. For Japan and Norway, also very expensive countries, the same phenomenon occurs at market exchange rates per capita GDP appears to be higher than in the U.S., but using PPP exchange rates it is actually much lower. For countries with a lower cost of living, such as Mexico, Turkey, and the Czech Republic, using the PPP exchange rate raises their per capita GDP figure. Mexican per capita GDP was $4,298 in 1997 when calculated using market exchange rates (8 pesos/dollar) but was $7,697 using PPP exchange rates (4.4 pesos/dollar). PPP exchange rates can be found at www.oecd.org
Media Illustrations
Example 1
This is the reason why the fixed exchange rate system was scrapped in 1971. The U.S. had been pursuing an inflationary monetary policy to help pay for the Vietnam war and new social programs, and its trading partners did not all want to participate in it.
What is an inflationary monetary policy?
Inflation results from increasing the money supply at a rate greater than the real rate of growth of the economy.
What are the three basic ways of paying for the Vietnam war and new social programs? To which does the ''inflationary monetary policy" refer?
This government spending must be financed by raising taxes, selling bonds to the public, or printing money (selling bonds to the central bank). The last of these is most directly tied to inflation.
What is forcing U.S. trading partners to participate in this inflationary monetary policy?
Under a fixed exchange rate a small open country is forced to experience the same monetary policy as the country to which its exchange rate is fixed. In this example the trading partners had fixed their exchange rates to the U.S. dollar.
If the fixed exchange rate system were scrapped, what exactly would these trading partners have to do to opt out of participating in this inflationary monetary policy?
They would have to reduce their money-supply growth rate to produce the long-run inflation rate they desire, and allow their exchange rate with the U.S. dollar to rise continually, at a rate equal to the difference between the U.S. rate of inflation and their own.
