Unit 4 Macro: GDP and PPP Adjustments

Gross domestic product (GDP) is the total value of output in an economy and is used to measure change in economic activityGDP for different countries is usually measured in a common currency – normally we use the US dollar. But there are two problems in using exchange rates to measure GDP

1. Exchange rates can be volatile from month to month and from year to year. For example a large depreciation in the value of the Argentinean peso against the US dollar might imply that Argentinean living standards have fallen even though their economy might actually be growing quite quickly

2. Exchange rates are more relevant to products that are traded between countries rather than non-traded products. Manufactured goods tend to sell for similar prices in most parts of the world – this is because international competition tends to reduce the differentials in prices for similar products. Non-traded service such as domestic cleaners, haircuts and academic tutors tend to have bigger differences in prices.

Calculations of GDP based on market exchange rates tend to over-estimate the cost of living in poorer developing countries. This is called the Balassa-Samuelson effect.

To make a PPP adjustment for comparing GDP we build a basket of comparable goods and services and look at the prices of that basket in different countries. Purchasing Power Parity is the exchange rate needed for say $100 to buy the same quantity of products in each country.

The Big Mac Index looks at the implied PPP exchange rates between countries and the actual exchange rates and uses this data to see if a currency is under or over-valued against the US dollar.

The data above is taken from Big Mac Index data for January 2012.

• The baseline data finds that a Big Mac costs an average of $4.20 in the United States and 3,700 South Korean won.
• If actual exchange rates were at their implied PPP levels, then the South Korean – US dollar exchange rate would be $1 = Won 882.
• In fact the Won is weaker than that against the dollar ($1 buys Won1159) which suggests that the Won is under-valued against the US dollar.
• So too – using the data above – is the Chinese Yuan and also the India Rupee whereas currencies such as the Brazilian Real and the Australian Dollar are over-valued on a PPP basis.

Data from the World Bank uses a huge amount of price data for different countries in order to calculate a PPP-adjusted level of GDP. But there are problems in making international comparisons across countries:

• Types of product – rice seems to be homogeneous but it isn’t!
• Differences in the quality of a good or service are reflected in price variations
• Differences in consumption weights – for example average per capita consumption of cheese or popcorn or chocolate reflects household preferences between countries - these can vary by large amounts
• Many goods and services are not bought and sold in markets and therefore do not have official prices – in many countries there is a large informal and/or subsistence sector
• The quality of economic data varies across countries – many nations do not have sophisticated methods of collecting information

Despite these problems, PPP-adjusted real GDP will continue to be the key way in which we measure the total value of a nation’s output of goods and services, and to guide understanding of what is happening to average living standards between countries.

Click here for a video explanation of the Big Mac Index