The ideal method for comparing the outputs of two countries is to value the two countries productions of final goods in services using the same set of prices. In practice this is impractical because in any modern industrial country there are millions of different goods and services. The usual procedure is to value each country's output in its own set of prices. This gives each country's GDP in its own currency; i.e., Japan's output in yen and the U.S.'s output in dollars. The next step in a comparison is to convert one country's output into the other country's currency. The obvious method of conversion is to use the exchange rate.
The problem with using the market exchange rate is that it fluctuates so the converted output of a country will rise and fall with the exchange rate. This measure of output suggests fluctuation in the output of a country that is just not occurring.
The World Bank developed an alternate method of converting a country's output into currency of another country. The method is called Purchasing Power Parity (PPP). It finds a conversion rate between two country's currency based upon the relative buying power of the currencies. The way the PPP exchange rate is computed is to determine the cost of a market basket of goods and services in the two countries. For example, for a PPP exchange rate betweeen the yen and the dollar, the value is given by:
This PPP exchange rate is then used to convert the yen value of the GDP of Japan into dollars.
The market exchange rates should be the same as the PPP exchange rates in the long run. In the medium and short term the market exchange rate is strongly influenced by interest rates and political events.