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GDP per capita adjusted for Purchasing Power Parity (PPP) in the world, 2009
Purchasing Power Parity adjustment for the world (2003). The economy of the United States is used as a reference, and is set at 100. Bermuda has the highest index value at 154; this means that goods sold there are more expensive than in the US. Purchasing power parity (PPP) is a measure of long-term equilibrium exchange rates based on relative price levels of two countries[citation needed]. The idea originated with the School of Salamanca in the 16th century [1] and was developed in its modern form by Gustav Cassel in 1918.[2] The concept is founded on the law of one price, the idea that in absence of transaction costs and official barriers to trade, identical goods will have the same price in different markets when the prices are expressed in terms of one currency.[3] In its "absolute" version, the purchasing power of different currencies is equalized for a given basket of goods. In the "relative" version, the difference in the rate of change in prices at home and abroadthe difference in the inflation ratesis equal to the percentage depreciation or appreciation of the exchange rate. Deviations from the theory imply differences in purchasing power of a "basket of goods" across countries, which means that for the purposes of many international comparisons, countries' GDPs or other national income statistics need to be "PPP adjusted" and converted into common units. The best-known purchasing power adjustment is the GearyKhamis dollar (the "international dollar"). The real exchange rate is then equal to the nominal exchange rate,
adjusted for differences in price levels. If purchasing power parity held exactly, then the real exchange rate would always equal one. However, in practice the real exchange rates exhibit both short run and long run deviations from this value, for example due to reasons illuminated in the BalassaSamuelson theorem. There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates.[4] For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity[5]considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, when converted via the nominal exchange rates GDP per capita in India is about US$1,704.063[6] while on a PPP basis it is about US$3,608.196.[7] This means that if calculated at nominal exchange rates, India has the tenth largest economy, while at PPP-adjusted rates, it has the fourth largest economy in the world. At the other extreme, Denmark's nominal GDP per capita is around US$62,100, but its PPP figure is only US$37,304.
Contents
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1 PPP measurement o 1.1 The Relationship Between PPP and the Law of One Price o 1.2 Big Mac Index o 1.3 Starbucks tall latte index o 1.4 Measurement Issues o 1.5 2005 ICP 2 Need for PPP adjustments to GDP 3 Difficulties o 3.1 Range and quality of goods o 3.2 Trade Barriers and Nontradables o 3.3 Departures from Free Competition o 3.4 Differences in Consumption Patterns and Price Level Measurement 4 PPP and Global Poverty Lines 5 See also 6 Notes 7 External links
difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared. For example, in 2005 the price of a gallon of gasoline in Saudi Arabia was $0.91 USD, and in Norway the price was $6.27 USD.[8] The significant differences in price wouldn't contribute to accuracy in a PPP analysis, despite all of the variables that contribute to the significant differences in price. Further comparisons have to be made and utilized as variables in the overall formulation of the PPP. When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.
[edit] The Relationship Between PPP and the Law of One Price
Although it may seem as if PPP and the law of one price are the same, there is in fact a difference: the law of one price applies to individual commodities whereas PPP applies to the general price level. If the law of one price is true for all commodities then PPP is also therefore true; however, when discussing the validity of PPP, some argue that the law of one price does not need to be true exactly for PPP to be valid. If the law of one price is not true for a certain commodity, the price levels will not differ enough from the level predicted by PPP.[3] The purchasing power parity theory states that the exchange rate between one currency and another currency is in equlibirium when their domestic purchasing powers at that rate of exchange are equivalent. Example: -- Suppose that one USD is currently selling for ten Mexican Pesos (MXN) on the exchange rate market. In the US baseball bats selling for $40 while in Mexico they sell for 150 pesos. Since 1 USD = 10 MXN, then the bat costs 40 USD if we buy it in US but only 15 USD if we buy it in Mexico. Clearly, there's an advantage to buying the bat in Mexico, so consumers are much better off going to Mexico to buy their bats.
Big Mac hamburgers, like this one from Japan, are similar worldwide. Main article: Big Mac Index An example of one measure of law of one price, which underlies purchasing power parity, is the Big Mac Index popularized by The Economist, which looks at the prices of a Big Mac burger in McDonald's restaurants in different countries. By determining whether a currency is undervalued or overvalued, the index should give a guide to the direction in which currencies should move. The Big Mac Index is presumably useful because it is based on a well-known good whose final price, easily tracked in many countries, includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc. This index provides a test of the law of one price, but the dollar prices of Big Macs are actually different in different countries. This can be explained by a number of factors: transportation costs and government regulations, product differentiation, and prices of nonfood inputs.[3] Furthermore, in some emerging economies, western fast food represents an expensive niche product price well above the price of traditional staplesi.e. the Big Mac is not a mainstream 'cheap' meal as it is in the West, but a luxury import for the middle classes and foreigners. This relates back to the idea of product differentiation: few substitutes for the Big Mac allows McDonald's to have market power.
Britain +17 Canada -16 China -1 Euro area +33 Hong Kong +15 Japan +13 Malaysia -25 Mexico -15 New Zealand -12 Singapore +2 South Korea +6 Switzerland +62 Taiwan -5 Thailand -31 Turkey +6
+23 -16 -56 +24 -45 -12 -53 -21 -4 -31 0 +82 -21 -46 +5
The 2005 ICP round resulted in large downward adjustments of PPP (or upward adjustments of price level) for several Asian countries, including China (-40%), India (-36%), Bangladesh (42%) and the Philippines (-43%). Surjit Bhalla has argued that these adjustments are unrealistic. For example, in the case of China, backward extrapolation of 2005 ICP PPP based on Chinese annual growth rates would yield a 1952 PPP per capita of $153 1985 International dollars, but Pritchett has persuasively argued that $250 1985 dollars is the minimum required to sustain a population, or has ever been observed for more than a short period. Therefore, both the 2005 ICP PPP for China and China's growth rates cannot both be correct. Angus Maddison has calculated somewhat slower growth rates for China than official figures, but even under his calculations, the 1952 PPP per capita comes to only $229. Angus Deaton and Alan Heston have suggested that the discrepancy can be explained by the fact that the 2005 ICP examined only urban prices, which overstate the national price level for Asian countries, and also the fact that Asian countries adjusted for productivity across noncomparable goods such as government services, whereas non-Asian countries did not make such an adjustment. Each of these two factors, according to him, would lead to an underestimation of GDP by PPP of about 12%.
Gross domestic product (by purchasing power parity) in 2006 The exchange rate reflects transaction values for traded goods between countries in contrast to non-traded goods, that is, goods produced for home-country use. Also, currencies are traded for purposes other than trade in goods and services, e.g., to buy capital assets whose prices vary more than those of physical goods. Also, different interest rates, speculation, hedging or interventions by central banks can influence the foreign-exchange market. The PPP method is used as an alternative to correct for possible statistical bias. The Penn World Table is a widely cited source of PPP adjustments, and the so-called Penn effect reflects such a systematic bias in using exchange rates to outputs among countries. For example, if the value of the Mexican peso falls by half compared to the U.S. dollar, the Mexican Gross Domestic Product measured in dollars will also halve. However, this exchange rate results from international trade and financial markets. It does not necessarily mean that Mexicans are poorer by a half; if incomes and prices measured in pesos stay the same, they will be no worse off assuming that imported goods are not essential to the quality of life of individuals. Measuring income in different countries using PPP exchange rates helps to avoid this problem.
PPP exchange rates are especially useful when official exchange rates are artificially manipulated by governments. Countries with strong government control of the economy sometimes enforce official exchange rates that make their own currency artificially strong. By contrast, the currency's black market exchange rate is artificially weak. In such cases a PPP exchange rate is likely the most realistic basis for economic comparison.
[edit] Difficulties
There are a number of reasons why different measures do not perfectly reflect standards of living.
labor is greater in rich countries than in poor countries. Nontradables tend to be labor-intensive; therefore, because labor is less expensive in poor countries and is used mostly for nontradables, nontradables are cheaper in poor countries. Wages are high in rich countries, so nontradables are relatively more expensive.[3] PPP calculations tend to overemphasise the primary sectoral contribution, and underemphasise the industrial and service sectoral contributions to the economy of a nation.
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