A very quick guide to what they mean. Every country in the world calculates Gross Domestic Product in essentially the same way, by adding up the value of everyone's everyone's value-added (or income or consumption, they should all be the same) and coming to a total figure, taking care not to double count (ie only count the value added by each person, not the total product). Now obviously this will be measured in domestic currency, so you get $12,000 bn for the US, £1,210for the UK, 450,000bn yen for Japan, etc etc.
When comparing internationally the problem is then how to convert these figures into the same unit. The simplest, and most obvious way, is to use market exchange rates and convert them all into US$. So for the UK you take today's exchange rate of $1.57 to £1, and work out that £1210bn is $1,900bn (these are only rough figures).
The problem with this measure is twofold. First it means that large currency movements seem to imply large changes in comparative GDP. For example, when sterling fell out of the exchange rate mechanism it fell by about 20%. This would imply that vis-a-vis Germany and France the UK's economy suddenly got 20% smaller, which is clearly nonsense. More recently, the rise in the pound pushed Britain's economy above that of France, the recent fall threatens to make it once more smaller. Clearly there are ways around this problem, such as taking the average exchange rate for the last 3 years.
More fundamentally exchange rates can get way out of line with 'fundamentals'. When comparing countries' output one is implicitly assuming that prices are generally the same for the same goods. Otherwise the comparision is misleading. Imagine for example that Switzerland produces 100 apples a year and so does Britain, but according to market exchange rates Swiss apples fetch $10 and British ones only $1. That would mean Swiss output was $1000, British $100, even though they have the same output.
In a free-market world this situation shouldn't arise, as Britain would export apples to Switzerland, thus seeing Swiss francs flow out to Britain, and the Swiss exchange rate fall, thus bringing the international price of their apples down. This is known as the 'law of one price', i.e. goods should cost the same all over the world.
However, particularly in the case of developing countries with currencies that are rarely traded, or as in the case with China, where exchange controls and other government intervention prevent market mechanisms working, this situation does not arise. Even with freely floating currencies exchange rates can get out of line as many goods, such as services (e.g. haircuts) are not traded, so even a huge imbalance in price between the UK and Switzerland would be unlikely to be corrected. (For more information see The Economists' Big Mac index).
Anyway, economists have therefore come up with Purchasing Power Parity exchange rates, which simply attempt to find a 'correct' exchange rate between countries to equalise the price of a basket of goods. For reasons outlined above, for developed countries these tend to be similar to market exchange rates, but for developing countries they can be very different. Noticeably both in India and China the price of goods is much cheaper than in (say) the US, and so market exchange rates make them seem poorer than they 'actually' are. Thus on a PPP basis China's GDP is about $6,000 per heard, on a market exchange rates basis it is about $1,000 per head.
Which one is better? It might look as if the PPP one is better, and it does provide a better indication of living standards within a country. When looking at international clout now market exchange rates are probably more useful. After all, imports are paid for in real dollars, not PPP dollars. Over time though PPP might be a better guide to the way things are heading -- one would expect China's exchange rate (if it were freely floating) to rise towards its PPP level as China got richer (note however PPP exchange rates as a guide to exchange rate forecasting are notoriosly inaccurate).
posted by Matthew @ 4/15/2003 04:56:00 PM
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