The DAC deflators adjust for both price and exchange rate changes, so that all flows, from all donors, in all years, are expressed in terms of a readily understood fixed unit of measurement - the purchasing power of a US dollar in a recent year, referred to as the base year.
Starting from data expressed in nominal terms, i.e. in United States dollars at the exchange rate prevailing at the time of the flow, conversion to reflect the purchasing power of dollars in a given base year requires two adjustments:
1. Replacing the exchange rate that prevailed at the time of the flow by the exchange rate in the (recent) base year.
2. Allowing for inflation in the currency in which the flow occurred between the year of the flow and the base year.
Hypothetical example: Say Japan gave 30 billion yen in aid in 1966, when there were 300 yen to the dollar. Its aid was therefore worth $100m at the time. We wish to express this in 2006 dollars, i.e. in terms of what a dollar would buy in 2006, including what it would buy in Japan. Assuming that prices doubled in Japan between 1966 and 2006, 30 billion yen in 1966 was worth 60 billion yen in 2006. Assuming also that there were 100 yen to the dollar in 2006, this 60 billion yen was worth 600m. 2006 dollars. (Notice that inflation in dollars does not enter this calculation.)
The same result can be obtained working backwards from the fixed unit of measurement, 2006 US dollars. In 2006, 600m. dollars bought 60 billion yen. This 60 billion yen only bought as much as 30 billion yen had bought in 1966. So 600m. 2006 dollars has the same buying power as 30 billion 1966 Japanese yen.
The DAC deflators combine the two adjustments. First the exchange rate: in the above example, the dollar was worth 0.333 times as many yen in 2006 as in 1966. Next, inflation: the yen only bought 0.5 times as much in 2006 as in 1966. The deflator is then 0.33*0.5=0.167. To convert the 1966 flow expressed in 1966 dollars to 2006 dollars, divide them by this deflator, i.e. $100m./0.167 = $600m.
The deflators shown here (*) are calculated in this way (they are expressed as percentages rather than proportions, so the result needs to be multiplied by 100). The exchange rates used are the annual averages of daily spot rates against the dollar, as calculated by the OECD Economics Directorate. The inflation figures used are the OECD's series of GDP implicit price deflators for each currency, with par set at the base year.
To sum up, the DAC deflators convert dollar-denominated data for any year to dollars with the purchasing power they had in a specified base year (in this case, 2006). Converting a flow expressed in current dollars from country X in year Y into 2006 dollars requires dividing it by the 2006-base deflator for country X and year Y (and multiplying by 100).
Conversion using the deflators removes the effect of both inflation and exchange rate changes on nominal figures, allowing comparison in a fixed and readily understood unit of measurement of aid given at different times and in different currencies.
(*) “Total DAC” deflator
DAC publications include a deflator for “total DAC” flows. This is the average of the deflators of individual DAC donors, weighted by each donor’s total ODA. This should only be used to give a rough idea of total aid flows when the currency of some of the flows is not known (e.g. when part of the flows come from the multilateral agencies who may disburse in various currencies). In all other cases, deflators of individual donors should be applied, i.e. data for total DAC flows are obtained by adding up the deflated amounts for each DAC donor.
Reference DAC Statistical Tables