Welcome. Today, we're going to be looking at GDP,
gross domestic product,
and PPP, purchasing power parity.
These are very useful concepts
if we want to compare the economy of two different countries.
Let's take a look.
Gross domestic product, as you probably know,
is the market value of all final goods and services produced
within a country in a year.
I'm not going to say so much about gross domestic product,
and its problems, and its measurement
because you can find this material in just about any textbook.
Of course, I recommend that you choose the best textbook.
Let's move on.
The problem we want to solve is this:
how do we compare, let's say, 2010 US GDP of 14.5 trillion dollars
with the GDP of Thailand
which, in Thailand, is measured as 9.5 trillion baht?
Well, the obvious idea is to use exchange rates.
And, indeed, if we do this,
we find that 1 dollar is equal to about 31 baht at this point of time.
So, Thai GDP by this measure is approximately 300 billion US dollars.
There are two problems, however, with using exchange rates to convert GDP.
The first is that exchange rates swing a lot,
and this implies implausibly large swings in the standard of living.
So, it wouldn't be at all impossible, for example,
for the Thai to US dollar to baht exchange rate to swing by,
you know, 30% within a couple of months, either up or down.
But this just implies --
much bigger changes in the standard of living
in these two countries than is really very plausible.
The second problem --
is that exchange rates are more relevant to goods that,
in fact, are exchanged to tradables --
and less relevant to non-tradables such as many services.
In fact, it turns out that non-tradables tend to be cheaper in poorer countries.
That's an important fact we want to say a little bit more about.
Manufactured goods tend to sell for similar prices everywhere.
This is the law of one price for tradables.
So, for example, if you want to buy an iPad,
it's going to cost you about 500 dollars, whether you buy it in the United States,
whether you buy it in France after you've converted the currency,
whether you buy it in China,
even if you buy it in Outer Mongolia,
it's still going to cost you, when all is said and done,
about 500 dollars.
And the reason for this is:
imagine that iPads were selling for 300 dollars in Outer Mongolia.
iPads are tradable,
they can easily be moved around.
So, if iPads were selling for 300 dollars in Outer Mongolia
and 500 dollars in the United States,
it would make sense to buy iPads in Outer Mongolia for 300,
ship them into the United States,
sell them there for 500 until the prices equalize.
The same is not true for services.
Services tend to be quite a bit cheaper in poorer countries.
You can get cheap haircuts, cheap cooks,
and cheap house cleaners in a poorer country.
This is because labor is non-tradable.
Labor, at least in our world, is immobile.
So, for example, you can get a cheap cook in India,
an expensive cook in the United States,
but you don't see lots of cooks moving from India to the United States,
at least not compared to the numbers of people who could move.
So, the exchange rate,
because of this, is more closely related to the relative price of tradable goods.
Tradable goods will be exchanged through the arbitrage process I just discussed
until, in fact, the exchange rate makes it such that
tradable goods sell for about the same price everywhere
once you've done all the currency conversions.
The same is not true for labor.
The same is not true for service goods, for goods,
for non-tradables, for immobile goods.
So, as a result of this,
calculations of GDP based on exchange rates --
tend to overestimate the cost of living in poorer countries --
because they take into account that tradables are about the same price
but not that non-tradables are cheaper in poorer countries.
This is called the Balassa–Samuelson effect
and you can find more about it by listening to the video on Béla Balassa.
Okay. Given this, how do we compare GDP of two different countries?
Well, we're going to use a method very similar to what we do
to compare GDP over time in the same country.
So, let's remember what nominal GDP is.
So, nominal GDP is just the market value of all final goods and services sold
in a country within a year.
So, for example, if we want to look at nominal GDP in the United States in 2005,
that's 2005 prices times 2005 quantities;
turns out to be equal to 12.4 trillion dollars.
If we look at 1995 GDP in the United States,
that's 1995 prices times 1995 quantities
at 7.4 trillion dollars.
The growth of nominal GDP, then subtracting these numbers,
that turns out to be equal to 67.6%.
We really don't think, however,
that the growth and living standard has gone up by 67%
between 1995 and 2005.
The growth of nominal GDP over this ten-year period
includes price increases as well as increases in output.
So, the solution to this problem is to calculate GDP in each year
using the same set of prices.
So, for example, we can calculate 2005 GDP,
just as we did before,
as 2005 prices times 2005 quantities.
That's, again, 12.4 trillion dollars.
Now, however,
let's calculate 1995 GDP in 2005 dollars.
That is, we're going to use 2005 prices times 1995 quantities.
That gets us 1995 GDP in 2005 dollars
and that's 9.0 trillion dollars.
So, the growth rate of real GDP --
turns out to be 37.8%.
Not bad, but not the 67% that we saw earlier.
So, the idea here is that using the same set of prices
eliminates the effect of price changes on GDP.
Let's try the same trick for comparing the economies of two different countries.
So, to compare GDP over time,
we create a basket of goods, which is comparable over time,
and we look at how the price of that basket changed over time.
So, we can find, for example, that a basket of goods which cost $10 in 1915;
we can trace that same basket all the way through 2005
where it cost 207 dollars.
We can use that series of price changes
to calculate real GDP over time.
Let's use the same idea for comparing GDP between countries.
We need to create a basket of goods which is comparable between countries
and look at the prices of that basket in different countries.
If we do this and we find, for example,
that the price for the basket is Pa in country A
and Pb in country B,
then the purchasing power parity ratio is Pa/Pb.
That is, the number of units of country A's currency
that are needed to purchase the same basket of goods and services
as one unit of country B's currency will purchase in country B.
Okay, that's kind of a mouthful, so let's give an example.
Let's take a look at the most famous purchasing power parity ratio or index,
the Big Mac Index, which is produced by The Economist.
The Big Mac is a basket of goods.
It's a basket of bread, and beef, and cheese, and onions,
and also the labor required to cook these products and to deliver them.
So in the United States, this basket of goods
can be bought for about 4 dollars and 45 cents.
In Thailand,
the exact same basket, the same Big Mac,
you can buy it for 70 baht.
What that suggests, for example, --
is that somebody who earns 70 baht an hour in Thailand
has above the same standard of living
as somebody who earns 4.45 dollars an hour in the United States.
Notice, however, that the actual exchange rate is not
1 dollar to 15.74 baht,
it's actually 1 to 29.6 baht.
In other words,
if you take that 70 baht in Thailand and you convert it into dollars,
you're only going to get 2 dollars and 36 cents.
This might suggest, if you used the exchange rate
to look at standard of living,
this would suggest that somebody who earns 70 baht an hour in Thailand,
actually, has a standard of living equivalent only
to 2.36 dollars an hour in the United States
while, in fact, we know the actual equivalent is
4.45 dollars an hour.
We know that the person in Thailand can afford a Big Mac,
not just half a Big Mac as the exchange rate would suggest.
Well, why is this?
Well this is the Balassa–Samuelson effect.
It's the fact that the Big Mac contains a labor component.
And labor is cheaper in Thailand --
which means that it's cheaper to live in Thailand than you would expect
from the exchange rate alone.
Another way of putting that,
is that people in Thailand have a higher standard of living
than you would expect given the exchange rate alone.
This is why we want to convert using purchasing power parity ratios
rather than using exchange rates.
By the way, you can also see that --
down here, where it's actually cheaper to live,
these tend to be poorer countries.
Well, up here, where the exchange rate is, you could say, overvalued,
where a Big Mac cost you 8 dollars for example in Norway,
these tend to be the richer countries.
Again, this is very consistent with the Balassa–Samuelson effect.
So, remember, we want to convert using the purchasing power parity ratios
in order to take into account that some goods,
particularly non-tradable goods,
are cheaper in poorer countries.
And we do that by using the same basket of goods in all countries.
The Big Mac index gives us the right idea,
but we'd really like a bigger basket of goods.
After all, the Big Mac doesn't include everything.
So, this is what the World Bank's International Comparison program does.
It creates a very large basket of goods to try and create PPP adjusted real GDP.
By the way, when you do this, Thailand's GDP based on exchange rates
is 300 billion.
When you do it based on PPP which, for all the reasons we've discussed,
is a more accurate account of the strength of an economy or the standard of living,
it's 585 billion, a larger number.
Now, it's very difficult to make real GDP comparisons over long periods of time.
This is because it's difficult to find
a comparable basket of goods over periods of time.
We consume a lot of goods today like iPads
which simply weren't available 20 years, let alone 80 years ago.
We also changed our consumption patterns over time.
So, we consume a lot fewer horseshoes today
than we did a hundred years ago.
But if horseshoes are a little bit more expensive today,
you wouldn't want to say that
that means our standard of living has gone down a lot.
Goods change in quality over time as well.
We have very similar problems when we're trying to make comparisons of
GDP between very different countries.
Let's take a look.
So, how we're going to make this international basket comparable?
We have a number of problems. First, I'll call the rice problem.
Well, rice seems like something we ought to be very easily able
to compare across countries.
But, yet, when you look in more detail, you say:
well, are you comparing long grain rice or short grain rice?
brown rice or white rice?
Uncle Ben's or Kismet rice?
So, all kinds of different types of rice,
and we need to try as best as we can to make account of those differences.
There's also what I call the croissant problem.
For some reason, croissants are just a lot better in Paris
than they are in Washington DC.
You can go to a bakery right off the street in Paris
and the croissant just tastes a lot crunchier, and crisper,
and yet soft inside than the one you buy in Washington DC.
So, there are quality differences which we'd like to take into account,
if we possibly can.
But, of course, that is hard to do.
Then, there's the cheese problem or the consumption weight problem.
We consume a lot of cheese in the United States.
They don't consume very much in China.
So, if cheese is more expensive in China than it is in the United States,
that doesn't mean that the Chinese have a lower standard of living
because they don't want to buy the cheese anyway.
So, we have to try and take it into account.
This basket of the goods has to be comparable across countries.
So, we don't want to use the US consumption ratios.
In fact, we don't want to use the Chinese consumption ratios either.
We want to try and create some middle ground.
Then, there's a health care problem.
How do you measure the prices of goods which aren't bought and sold in markets?
Health care is a big part of GDP --
and yet, for the most part,
we don't have prices for a heart surgery,
or for diabetic treatment, or something like this.
So, in these cases,
we usually measure by the cost of the inputs
which is not as good a solution.
Then, everything that I've said so far also applies.
We want to look at producer goods, you know, the welding equipment.
How are you going to find comparable welding equipment?
So, everything I've said about consumption goods,
creating a basket of consumption goods,
we also want to include in there, producer goods.
So, that just adds to our problems.
The quality of data in poorer countries also tends to be quite poor.
So, this motivates other ways of trying to figure out
what GDP or standard of living is like.
Electricity consumption is another proxy for standard of living.
And you can actually estimate this,
and Henderson, Storeygard, Weil did this in a paper called
"Measuring Economic Growth from Outer Space"
by looking at the lights at night.
Here's a famous picture: this is from my textbook with Tyler,
showing South Korea down here.
Lots of lights. Lots of action.
This is at night. Lots of people going on to parties.
This is North Korea up here. Pretty quiet.
You can therefore see, just by looking at the lights,
that North Korea is a much poorer country than South Korea.
You can look at this, not just at a point in time,
but you can actually see the lights coming on.
You can actually see economic growth as it happens.
In China, for example, you see literally the lights turning on at night
as the country becomes richer.
So, this is another way of trying to get at some of these issues.
So, what's the bottom line?
Well, the bottom line is, despite some problems,
PPP adjusted GDP or real GDP,
it's a very useful statistic for comparing countries.
So, we can look at the total GDP of the United States,
this is in 2007,
was 12.9 trillion dollars.
The real GDP per capita was 42.8.
You can compare that with China which had a very large total GDP,
8.4 trillion, almost as large as the United States.
The GDP per capita, however, was much much lower.
India even lower yet.
So, even though it's imperfect,
these real PPP adjusted GDP statistics
are very useful for comparing countries
and for looking at how countries are growing over time.
Thanks.