Abstract
The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
Aggregation of economic indicators across countries frequently involves the calculation of weighted averages. A widely employed approach is to define countries’ weights as their shares in total GDP of the group considered. In order to ensure that these weights reflect shares in real output and not differences in price levels across countries, conversion factors based on purchasing power parities (PPPs) should be used to convert data in national currencies into a common numeraire currency. Nonetheless, for practical reasons, market or official exchange rates are widely used to convert real GDP.
The paper examines GDP weights based on exchange rates and on PPPs and discusses the implications of alternative weighting schemes for the derived aggregate economic indicators. A brief review of the literature on the relationship between exchange rates and prices suggests that market exchange rates are poor proxies for PPPs as conversion factors. The results from time-series analyses indicate frequent and prolonged deviations from PPP in the postwar period, and cross-country comparisons have revealed a systematic bias in GDP data converted at market or official exchange rates. Moreover, weighting systems based on exchange rates often involve a rather arbitrary choice of the base year and—as in the weighting system currently used in the World Economic Outlook—frequent ad hoc adjustments to account for large discrete changes in official exchange rates or changes in the exchange rate regime. The paper shows that these relatively arbitrary decisions can have a significant impact on the weights and, hence, on the derived aggregates.
The estimates of PPP-based GDP produced by the International Comparison Program (ICP) for a significant number of countries and several benchmark years are a possible alternative to conventional exchange-rate-based GDP weights. The paper summarizes the methodology underlying these estimates and discusses problems relating to the extrapolation to non-benchmark years and non-benchmark countries. Aggregates of real GDP growth based on PPP weights are compared with the corresponding aggregates based on the current WEO weighting system in order to illustrate the implications of using PPPs as conversion factors. The main conclusion of the paper is that GDP weights derived from the available estimates of PPPs, while not perfect and in some cases subject to substantial errors, are a closer approximation of real output shares than weights based on exchange rates.