Purchasing Power Parities of the Dollar and Euro

Currently the euro has a purchasing power parity (PPP) of 0.865 vis-à-vis the dollar based on tradables: a basket of internationally traded manufactured goods and tourist services which costs 1 € in the euro zone, comes at 0.865 $ in the USA. In view of an exchange rate of 0.958 $ and based on tradables, the euro was thus overvalued against the dollar by 10.7 percent in mid 2000. Taking an overall economic basket, however, the PPP was 1.078. One GDP unit thus came cheaper by 11.2 percent in mid 2000 in the euro zone than in the USA, so that the euro was undervalued when based on the GDP. The main reason for the discrepancy, i.e., that a GDP unit is cheaper and a unit of tradables is more expensive in the euro zone than in the USA, is the fact that services which are not traded internationally, such as health and education services, are especially expensive, whereas manufactured goods and tourist services are relatively cheap in the USA. In general, the GDP-based PPP is an unsuitable measure of the "fair" level of an exchange rate inasmuch as no country enjoys a price advantage or disadvantage in international trade. After all, large parts of the GDP, and in particular most services and building investments, are hardly if ever traded internationally (in the USA these make up 70 percent of GDP, in the EU 62 percent). Export market shares held by the EU and USA develop closely in line with the tradable-based over- or undervaluation of the euro/ecu against the dollar. Thus, the ecu/euro exchange rate to the dollar between 1987 and 1999 was, on average, 32.6 percent above the PPP of tradables, while at the same time the EU's share of overall exports by the triad (EU, USA, Japan) declined from 68.4 to 63.2 percent, and that of the USA rose from 19.1 to 26.0 percent. Such relationships illustrate not only the impact of sustained price shifts in international trade on relative export growth, but also put calculated PPPs into a plausible light.