When you compare the size of economies, you should use an exchange rate to convert the GDP of one country, measured in its own currency, in order to compare it with the GDP of the other country. But which exchange rate to use?
One obvious choice is the market exchange rate. An equally obvious problem is that exchange rates fluctuate. If a country’s exchange rate strengthens by 10% in a certain month, that does not of course mean that the standard of living of the people of that country has increased by 10% during that month. When you compare savings using a market exchange rate, it’s a bit like measuring with a ruler that without warning grows and shrinks.
There is also a more subtle problem with using market exchange rates to compare economies. Let’s say that in one country housing, health care or higher education is much cheaper than in another country. As a concrete example, we often read that there is talk of moving or retiring to another country where the cost of living is much lower – where you can buy this beautiful house for a lot less than United States. If you just look at the total size of GDP for that country with lower prices, converted at the market exchange rate, you wouldn’t be able to say that due to the lower price level, GDP actually represents a higher amount of goods consumed than you might expect.
A common alternative is the “purchasing power parity” exchange rate. As the name suggests, these exchange rates are calculated to reflect the purchasing power of a currency in the country. The idea is not new: the first academic research using a PPP exchange rate was published in 1940. But in recent decades, the standard source for calculating PPP exchange rates has been the International comparison project to the World Bank, which published its report “Purchasing Power Parities and the Size of World Economies: Results of the 2017 International Comparison Program” (May 2020)
It is generally true that low-income countries have cheaper goods and services. So when you look at the purchasing power of their currency in their own country, it tends to be higher than what the market exchange rate would imply. Here is a figure showing the price levels across countries. The horizontal axis shows GDP per capita, so high income countries are on the right. The vertical axis shows the price level across countries. The figure helps explain why places like Mexico and Thailand are such popular tourist destinations and even retirement destinations for people from high-income countries: your income buys more in those countries.
Essentially, a PPP exchange rate adjusts for these differences in purchasing power. As a result, the use of PPP exchange rates makes the GDP of low- and middle-income countries. As the report notes: “In 2017, world production, measured by purchasing power parities (PPPs), was $ 119,547 billion, compared to $ 79,715 billion, measured by market exchange rates. . economies contributed around 16% of global PPP-based GDP, while upper-middle-income economies contributed 34%. At the same time, high-income economies contributed 49% in terms of market exchange rate, these shares were 8%, 28% and 64% respectively.
If the comparison is made using a PPP exchange rate, China’s economy was larger than that of the United States in 2017.
Here is an overview of the global economy measured in GDP per capita. The vertical axis measures the share of the world’s population – and the population is indicated by the height of each bar. Thus, the bars for China, India and the United States are particularly high. The horizontal width of the bar measures GDP per capita, using a PPP comparison. The light blue lines on the left show 2011; dark blue bars on the right show 2017. You can see a number of modest changes over this six-year period: the rise of China and India, Turkey is ahead of the Russian Federation in terms of GDP per capita, and others.
Two additional thoughts deserve to be conveyed. First, PPP exchange rates are explicitly intended to compare GDP, GDP per capita, and similar measures across countries, in order to make this useful adjustment for different price levels across countries. ‘other. For other uses, they may not be suitable. The report notes: “ICP PPPs are designed specifically for international comparisons of GDP. They are not designed for cash flow or trade flow comparisons. exports of goods and services should be made with market exchange rates, not PPPs. “
Second, it may have occurred to you that measuring price levels comparably in all countries of the world, in a way that adjusts for differences in the quality and availability of various goods and services, is a Herculean task. There’s a reason the estimated PPP exchange rates for 2017 are released in 2020: it takes time to put it all together. The report describes the methodology in detail, but there is room for skepticism. Indeed, back in 2010 Angus Deaton dedicated his presidential address to the American Economic Association (available for free online here) to detail the “weak theoretical and empirical foundations” of these measures. But to anyone who has read this far, it’s no surprise that flawed economic statistics can still be useful, when applied with context and caution.
A version of this article first appeared on Conversable economist.