In a market-based economy the choices households, producers, and governments make about the allocation of resources are influenced by relative prices, including the real exchange rate, real wages, real interest rates, and a host of other prices in the economy. Relative prices also reflect, to a large extent, the choices of these agents. Thus relative prices convey vital information about the interaction of economic agents in an economy and with the rest of the world.

     The exchange rate is the price of one currency in terms of another. Official exchange rates and exchange rate arrangements are established by governments. (Other exchange rates fully recognized by governments include market rates, which are determined largely by legal market forces, and for countries maintaining multiple exchange arrangements, principal rates, secondary rates, and tertiary rates.) Also see Statistical methods for information on alternative conversion factors used in the Atlas method of calculating gross national income (GNI) per capita in U.S. dollars.

     The official or market exchange rate is often used to compare prices in different currencies. Since exchange rates reflect at best the relative prices of tradable goods, the volume of goods and services that a U.S. dollar buys in the United States may not correspond to what a U.S. dollar converted to another country’s currency at the official exchange rate would buy in that country. Since identical volumes of goods and services in different countries correspond to different values (and vice versa) when official exchange rates are used, an alternative method of comparing prices across countries has been developed. In this method national currency estimates of GNI are converted to a common unit of account by using conversion factors that reflect equivalent purchasing power. Purchasing power parity (PPP) conversion factors are based on price and expenditure surveys conducted by the International Comparison Program and represent the conversion factors applied to equalize price levels across countries. See About the data for table 1.1 for further discussion of the PPP conversion factor.

     The ratio of the PPP conversion factor to the official exchange rate (also referred to as the national price level) makes it possible to compare the cost of the bundle of goods that make up gross domestic product (GDP) across countries. These national price levels vary systematically, rising with GNI per capita.

     Real effective exchange rates represent a nominal effective exchange rate index adjusted for relative movements in national price or cost indicators of the home country, selected countries, and the euro area. A nominal effective exchange rate index represents the ratio (expressed on the base 2000 = 100) of an index of a currency’s period-average exchange rate to a weighted geometric average of exchange rates for currencies of selected countries and the euro area. For most high-income countries, weights are derived from trade in manufactured goods among industrial countries. The data are compiled from the nominal effective exchange rate index and a cost indicator of relative normalized unit labor costs in manufacturing. For selected other countries the nominal effective exchange rate index is based on each country’s trade in both manufactured goods and primary products with its partner or competitor countries. For these countries the real effective exchange rate index is derived from the nominal index adjusted for relative changes in consumer prices. An increase in the real effective exchange rate represents an appreciation of the local currency. Because of conceptual and data limitations, changes in real effective exchange rates should be interpreted with caution.

     Many interest rates coexist in an economy, reflecting competitive conditions, the terms governing loans and deposits, and differences in the position and status of creditors and debtors. In some economies interest rates are set by regulation or administrative fiat. In economies with imperfect markets, or where reported nominal rates are not indicative of effective rates, it may be difficult to obtain data on interest rates that reflect actual market transactions. Deposit and lending rates are collected by the International Monetary Fund (IMF) as representative interest rates offered by banks to resident customers. The terms and conditions attached to these rates differ by country, however, limiting their comparability. Real interest rates are calculated by adjusting nominal rates by an estimate of the inflation rate in the economy. A negative real interest rate indicates a loss in the purchasing power of the principal. The real interest rates in the table are calculated as ( i – P ) / ( 1 + P ), where i is the nominal interest rate and P is the inflation rate (as measured by the GDP deflator).

• Exchange rate arrangements describe the arrangements furnished to the IMF by each member country under article IV, section 2(a) of the IMF’s Articles of Agreement. • Classification indicates how the exchange rate is determined in the main market when there is more than one market: floating (managed or independent), pegged (conventional, within horizontal bands, crawling peg, or crawling band), currency board (implicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate), and exchange arrangement (currency is pegged to the French franc, or another country’s currency is used as legal tender). • Structure shows whether countries have a unitary exchange rate or dual or multiple rates. • Official exchange rate is the exchange rate determined by national authorities or the rate determined in the legally sanctioned exchange market. It is calculated as an annual average based on monthly averages (local currency units relative to the U.S. dollar). • Purchasing power parity (PPP) conversion factor is the number of units of a country’s currency required to buy the same amount of goods and services in the domestic market as a U.S. dollar would buy in the United States. • Ratio of PPP conversion factor to official exchange rate is the result obtained by dividing the PPP conversion factor by the official exchange rate. • Real effective exchange rate is the nominal effective exchange rate (a measure of the value of a currency against a weighted average of several foreign currencies) divided by a price deflator or index of costs. • Deposit interest rate is the rate paid by commercial or similar banks for demand, time, or savings deposits. • Lending interest rate is the rate charged by banks on loans to prime customers. • Real interest rate is the lending interest rate adjusted for inflation as measured by the GDP deflator.

The information on exchange rate arrangements is from the IMF’s Exchange Arrangements and Exchange Restrictions Annual Report, 2004. The official and real effective exchange rates and deposit and lending rates are from the IMF’s International Financial Statistics. PPP conversion factors are from the World Bank. The real interest rates are calculated using World Bank data on the GDP deflator.