Attention Economy


Saturday, December 26, 2020

China’s Economy Set to Overtake US


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INTERNATIONAL GDP COMPARISON:
In order to compare the GDP figures of two countries it is first necessary to convert them to a common unit of account (say, the US dollar). A fundamentally important question that arises when one tries to convert local currency GDP values into their US dollar equivalent values is the following: 
What exchange rate do we use to make the conversion – market exchange rates or purchasing power parity (PPP) based exchange rates?

Using market exchange rates is problematic for several reasons:
  • Under floating exchange rates, currency values fluctuate considerably, even over a short period of time.
  • Using market exchange rates will result in a failure to account for the vast differences in the prices of many services and non-traded goods between rich and poor countries.
Hence, PPP-based exchange rate is often used for converting GDP data:
“GDP is measured in the currency of the country in question. That requires adjustment when trying to compare the value of output in two countries using different currencies. The usual method is to convert the value of GDP of each country into U.S. dollars and then compare them. Conversion to dollars can be done either using market exchange rates—those that prevail in the foreign exchange market—or purchasing-power-parity (PPP) exchange rates. The PPP exchange rate is the rate at which the currency of one country would have to be converted into that of another to purchase the same amount of goods and services in each country (see "Back to Basics" in the March 2007 issue of Finance & Development). There is a large gap between market and PPP-based exchange rates in emerging market and developing countries. For most emerging market and developing countries, the ratio of the market and PPP U.S. dollar exchange rates is between 2 and 4. This is because nontraded goods and services tend to be cheaper in low-income than in high-income countries—for example, a haircut in New York is more expensive than in Bishkek—even when the cost of making tradable goods, such as machinery, across two countries is the same. For advanced countries, market and PPP exchange rates tend to be much closer. These differences mean that emerging market and developing countries have a higher estimated dollar GDP when the PPP exchange rate is used”.

Here is a brief introduction to PPP exchange rates from the IMF: