Suppose we define the PPP exchange rate as the number of units of a foreign coun

Question

Suppose we define the PPP exchange rate as the number of units of a foreign country's currency that is required to purchase the same amount of goods and services in the foreign country as 1 USD would purchase in the US. You determine that you can purchase more goods and services in the PRC with 1000CHY than you can with 100USD.

a) If the current nominal exchange rate is 10CHY=1USD, will China's GDP measured in USD be greater in the current nominal exchange rate or using the PPP exchange rate?

b)Briefly explain why

Explanation / Answer

100 USD is able to buy less goods and services in PRC as compared to 1000 CHY. This means that 1 USD will be able to buy less than 10 CHY, and the prevailing exchange rate is 10CHY = 1USD.

Now suppose China produces X units of good and each of then costs 10 CHY, then China's GDP in CHY = X*10 = 10X CHY

China's nominal GDP using exchange rate of 10CHY = 1 USD is equal to 10X/10 USD = X USD

Note than 1 USD buys less than 10 CHY, hence 1 USD is not enough to buy what 10 CHY could buy = 1 unit of good

Hence, we need more than 1 USD to buy 1 unit of good

=> we need more than X USD to buy X units of good

=> PPP calculated China's GDP is greater than X USD

Hence, GDP calculated using PPP is greater tha GDP calculated using nominal exchange rate.

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