What are Purchasing Power Parity (PPP) and Purchasing Power Parity GDP?

Purchasing Power Parity (PPP) is a name that covers a number of loosely related ideas.  The most important, I think, are:

–PPP as a theory of predicting long-term exchange rate equilibria, and

–the calculation and comparison of country GDPs using PPP.

In the first sense, PPP answers the question of  what exchange rate would prevail in an ideal world where workers in different countries all have equal compensation.  In the second, PPP says what country GDPs should really be if the value of non-traded goods were factored into the calculation–not just traded goods.

PPP and currency values

PPP is a labor theory of value.  The basic idea is that the average worker, no matter what country he works in, should earn enough money to buy stuff that will give him the same standard of living as a worker in any other part of the world.  This is the equilibrium condition.  If, at any given time, this condition does not hold, currency exchange rates will realign themselves so that equilibrium is established.

I first encountered PPP as a practical thing when it came into vogue in the mid-Eighties, a period of great instability in exchange rates.   It was for a while the preferred method of currency forecasting.  It didn’t work very well, however.   Apart from the more general question of whether value of a good in trade is determined by the amount of labor expended in its making, there were three practical issues:

1.  tastes may differ from culture to culture, so determining “equal” baskets of goods and services across countries isn’t as easy at it sounds,

2.  in the real world, prices subject to local cartels or government regulation may change only very slowly, and

3.  other factors, like the emergence of substitutes or a significant change in the price level (think:  Japanese deflation in the Nineties) can do the work ascribed in this theory to currency movements.

Purchasing Power Parity GDP

GDP calculated under PPP is a different matter.  The issue first arose, I think, in connection with the rapid growth of the mainland Chinese economy during the Eighties, when it averaged double-digit annual expansion of real GDP.  This compares with the US, which averaged, say, 3%.    Whatever imprecision there may have been in the actual numbers reported by the two countries, it was clear that China had grown much, much faster than the US during the decade.

The conventional way to compare countries’ GDP is to take the local currency number for each economy and translate the result into come reference currency, typically the US$.  The common sense result guess for the Eighties would have been that China had doubled in size relative to the US during the decade.  But when the conventional calculations were done, China had actually shrunk in relation to the US.

The problem?–the conventional calculation uses market exchange rates, which express the relative price relationships among traded goods, like cars, and uses that relationship as a proxy for the value of all goods in an economy.  That doesn’t work well.  In an emerging economy, a haircut, a bus ride, even cellphone service will typically be much cheaper than in a developed economy.

Seeing the US/China result was enough to prompt the World Bank to attempt to make GDP calculations that included non-traded goods as well.  These are the 2008 World Bank figures.  The results are startling, though less so than they would have been two or three years ago, when Brazil, India and Russia would have had their approximate PPP rankings but would have been out of the top ten in the conventional ones:

—————–rank   % of world GDP         —–  rank    % of PPP GDP

US                         1                 23.4%                       1              20.3%

Japan                  2                    8.1%                        3               6.2%

China                 3                  7.1%                        2               14.3%

Germany             4                     6.0%                     5               4.2%

France                 5                     4.6%                     8               3.0%

UK                        6                     4.3%                     7                3.0%

Italy                      7                    3.8%                   10               2.6%

Brazil                  8                     2.6%                     9                2.9%

Russia                9                     2.6%                      6                 3.3%

Spain                10                     2.6%                    12                 2.0%

Canada             11                      2.3%                   14                1.7%

India               12                     2.0%                     4                 4.9%

Mexico             13                     1.8%                      11               2.2%

Note that China and India are together about the same size as the US as a percent of world GDP when measured by PPP, vs. less than 40% of the US when measured conventionally.

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