Comparing economies: How is economic size measured and why does it matter? Behind the Numbers, July 2016

How do we compare economies? GDP is generally measured in a country’s own currency, but for comparing economies, one must convert to a common measure. The choice of conversion factor can make a huge difference in our understanding of relative size.

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Humankind’s effort to measure and compare dates back thousands of years, to the beginning of civilization. Methods of measurement have evolved and grown in sophistication—from the length of an arm or the weight of a sheaf of wheat to standardized systems of associating numbers with physical quantities. However, converting one system of measurement to another can still be a daily challenge—think of an American athlete adding weight plates in kilograms or a French chef converting tasse à café to in a traditional Japanese kitchen. With the effort to convert also comes the challenge of comparing. Nowhere can this be starker than in the measurement of the size of economies.

Generally, the most common measure of the size of national economies is gross domestic product (GDP)—defined as the sum total of all goods and services produced within the borders of a nation less the value of the goods and services used up in production. However, with each nation measuring GDP in its local currency, comparisons can become a challenge. This is why economists generally use market exchange rates to convert GDP measured in local currency units to GDP in US dollars. However, this method may not be an appropriate answer to all questions, particularly for questions related to the size of an economy. An alternative is to measure GDP in current international dollars. An international dollar is a unit of a hypothetical currency defined such that one international dollar purchases the same basket of goods and services in a cited country as one US dollar does in the United States.1 This concept can be useful because it ties GDP comparisons to purchasing power, which is why it is referred to as purchasing power parity (PPP).

These two methods of comparing economies can yield very different understanding of relative size, particularly in the case of developing nations where GDP conversions at market exchange rates is usually much lower than GDP in PPP terms.

Market exchange rate versus purchasing power parity

Market exchange rates are determined by the demand and supply of currencies in financial exchange markets. A range of factors such as macroeconomic fundamentals, inflation, interest rate differentials, and trade influence the supply and demand for currencies. Comparisons of GDP across countries is generally achieved by conversion to US dollars at the market exchange rate (usually an average rate over a period of time). For instance, assume the US dollar buys 65 Indian rupees (INR) on average through 2015. India’s nominal GDP in rupees would therefore be divided by 65 to arrive at a comparable dollar figure. However, USD 10 (INR 650) would take you roughly 4 kilometers (2.5 miles) in a New York taxi while the equivalent in Indian rupees would take you about 10 times the distance in Hyderabad (in a very fancy auto-rickshaw). Though the comparison is not between perfect substitutes, it implies that a dollar would probably buy much more in India than the official market exchange rate indicates.

On the other hand, the PPP exchange rate between two currencies is that rate at which both currencies buy the same quantity of goods and services in each country. Therefore, in PPP terms, a dollar would probably exchange for less than INR 65 (so that USD 10 takes you the same distance in New York and in Hyderabad). The most often used example to illustrate PPP exchange rates is the Big Mac index developed by the Economist magazine in 1986. In this instance, rather than a basket of goods it is the price of a single Big Mac produced across countries that is used to determine relative exchange rates. According to the index, a burger in India costs INR 127 (approximately USD 2) in comparison to approximately USD 5 in the United States.2 This implies an exchange rate of roughly INR 25 per USD, far stronger than the market rate of INR 65 per USD.3 Using a market basket of goods and services, the PPP exchange rate is even stronger—INR 17.1 per current international dollar in 2015.  This leads to a much higher estimate (3.8 times) of the size of India’s economy than does a market exchange rate.4 Much of the reason behind this mismatch is that PPP takes into account nontraded goods and services, such as movie tickets, taxi rides, and haircuts, which involve labor-intensive production techniques and lower wages in developing nations. Such goods and services escape inclusion in market exchange rates.

Which is the world’s largest economy?

Comparisons of relative GDP size can change dramatically depending on whether PPP or market exchange rates are used, particularly in developing economies. When market exchange rates are used, the United States is the world’s largest economy, with China coming in a distant second. In fact, the United States is more than one-and-a-half times the size of China. Similarly, using market exchange rates, India is a smaller economy than Japan, Germany, the United Kingdom, and France. Other emerging and developing economies also appear relatively smaller when local currency GDP is converted to US dollars using market exchange rates. Therefore, the weights assigned to emerging and developing economies in the calculation of global growth can be smaller when GDP is calculated by market exchange rate, potentially skewing global growth measurement and subsequent comparisons.

In PPP terms, China is the world’s largest economy, ahead of the United States, accounting for 17 percent of global GDP and 33 percent of the change in global GDP in current international dollars in 2015.5 Likewise, India leapfrogs to the third-largest economy in the world, accounting for 7 percent of global GDP and 14 percent of the change in global GDP in 2015.6The United States accounts for 16 percent of global GDP but just 14 percent of the change in global GDP in 2015 (same as India).7 Indeed, emerging and developing economies as an aggregate assume much larger roles when measured in PPP terms, accounting for 56 percent of global GDP and 79 percent of global growth between 2010 and 2015.8Measuring global growth by using PPP weights to calculate the contribution of emerging and developing economies incorporates the increasingly important role played by this aggregate in the world economy.

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Advantages and drawbacks of the PPP alternative

One advantage of using PPP exchange rates to measure GDP is that PPP rates are relatively more stable than market exchange rates. Market exchange rates tend to be volatile especially when a currency is under speculative attack. Volatility in market exchange rates can cause significant shifts in GDP measurement. Another advantage is that PPP takes into account nontraded goods and services unlike market exchange rates. It could therefore be a more appropriate indicator of a national currency’s value within the nation’s borders. A difficulty though can be the formulation and tracking of a standard basket of goods and services across all countries—an extensive and tedious statistical challenge, affected by different factors in different countries.

Market exchange rates continue to be the method of choice when considering financial flows such as current account calculations. However, for questions related to size and contribution to global GDP and for comparing living standards across countries, the PPP method might just be the more appropriate approach. Matching method to question can influence everything from large-scale welfare programs and investment decisions of multinational companies to the travel plans of the globetrotter. Irrespective of the question, however, our measure of the size of an economy is still evolving and some of the shortfalls are becoming increasingly evident.