What are the drawbacks to using exchange rates to convert GDP to a common currency for making international comparisons (e.g. of production or productivity)?
There are two major disadvantages. First, exchange rates vary from day to day and sometimes change abruptly – perhaps because of speculation against a currency or because of changes in interest rates. If GDP is converted into a common currency using exchange rates, the size of a country’s economy can also appear to vary from day to day and undergo abrupt shifts for reasons that have nothing to do with the actual levels of economic activity in that country. This volatility can be overcome to some extent by using averaging devices, such as the Atlas method employed by the World Bank, although the results can be distorted if exchange rates change rapidly. A second disadvantage is that exchange rates do not simply reflect the relative prices of goods and services produced in a country – they are affected by the relative prices of tradable goods and by factors such as interest rates, financial flows etc. So the use of exchange rates to convert a service such as a haircut may give misleading
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