back to PPP comparisons

["michael a. lebowitz" <mlebowit@xxxxxx>]

I have just received some comments from a former colleague on the
questions posed about the use of PPP. They include his comments in a
letter plus an attachment which I have copied into the text below.
    in solidarity,
      michael
-------------------------
He writes:

I beg to disagree with the idea that the PPP method is
"imaginary" and the Atlas method is "actual". 
As I explain in the attachment, the PPP exchange rate takes into account
the price difference of goods and services between countries,or the
purchasing power of  a country's currency vis-a-vis the currencies
of other countries (or the US dollar), whereas the market exchange rate
does not take into account the price difference.

Take a simple example of Japan and the US.  Say the market exchange
rate is 110 Yens = One US$. Now take an equivalent basket--in quantity
and quality--that contains a burger with fries and a drink. It costs 450
Yens in Tokyo and US$ 2.50 in New York. The PPP exchange rate is then 180
Yens = One US$ (450/2.50). There is nothing imaginary about the PPP
exchange rate since it gives you the purchasing power of  a
country's currency vis-a-vis the US dollar.

The important point is that the market exchange rate seems to be a valid
conversion factor for settling payments between countries on account of
trade, debt, aid, etc. and the PPP exchange rate seems to be a valid
conversion factor for comparing the "standard of living"
of  people in different countries.

Now please turn to the data shown in my attachment Table. In the GNI
differences between the high income and middle + low income economies for
any year (1996, 1998, or 2002), our focus should be on the ratios
of  the GNI of high income countries to the GNI of middle + low
income countries under the Atlas and PPP methods separately. I see little
change in the ratios between 1996 and 2002: the GNI gap between the high
income countries and the middle + low income countries does not change
over time (compare the 1996 and 2002 data).

GNI (Atlas Method): in 1996 the ratio is 4.41 to 1.00 and in 2002 the
ratio is 4.18 to 1.00.
GNI (PPP Method): in 1996 the ratio is 1.36 to 1.00 and in 2002 the ratio
is 1.30 to 1.00.

The fact that the ratios of GNI between the high income and middle + low
income countries in each year differ so much under the two methods is
simply because the Atlas Method does not take into account the price
differences between countries and PPP Method does. There is no indication
that the income gap between the rich and poor countries has narrowed.
However, the income gap is larger with the market exchange rate compared
to the income gap with the PPP exchange rate.
----
The attachment:

Gross National Income (GNI) of Countries, 1996, 1998, 2002

GNI (Atlas
Method)                        
GNI (PPP Method)
                                                     
Billion US
Dollars                          
Billion US Dollars

Economy
                                            
1996          
1998          
2002          
1996          
1998          
2002
 
 
High
Income                         
23,772       
22,592       
25,596       
20,574       
20,745        27,516
Middle
Income                        
4,141         
4,401         
5,056         
8,305         
8,834        15,884
Low
Income                            
1,597         
1,842         
1,070         
6,809         
7,678          5,269
 
World                                   
29,510       
28,835       
31,720       
35,688       
37,136        48,462
 
 
Source: World Bank, World Development Indicators, 1998,
2000, 2004.
 
Notes:
 
1. Definitions:
 
·         Gross National
Income (GNI) = GDP plus net receipts of primary income (wages
and salaries plus property income) from abroad. GNI is a new term
used for the good old Gross National product (GNP): GNI and GNP have the
same formula.
·         Gross Domestic
Product (GDP) = Sum of value added by all resident producers
plus any product taxes (less subsidies) not included in the
valuation of output.
 
2. Internationally Comparable Values of GNI and
GDP:[1]
 
      The World Bank uses two methods for
estimating internationally comparable values of GNI and GDP.
 
·         The Atlas
Method: Each country?s GNI and GDP estimates (made in local currency)
are converted by using the ?market? exchange rate for its currency in US
dollars. The market exchange rate between currencies is a product of
several factors, including trade and capital flows. It is used for
financial transactions between countries (trade, debt services,
etc.). It should not be used to compare the GNI and GDP of countries
in the context of differences in their standard of living because the
market exchange rate does not take into account the price
difference between countries for goods and services.
 
·         The Purchasing Power
Parity (PPP) Method: The PPP exchange rate is simply the number of
units of a country?s currency required to purchase the same quantity of
goods and services (included in GDP) as one US dollar purchases in the
United States. In other words, this exchange rate reflects the
purchasing power of each country?s currency vis-à-vis the US
dollar. The PPP exchange rate for the poor countries tends to be higher
than the market exchange rate because prices of goods and services,
especially the non-traded ones, tend to be lower in poor countries than
in rich countries. In other words, the purchasing power of poor
countries? currencies vis-à-vis the US dollar is generally higher than
reflected by the market exchange rate. The PPP exchange rate is useful
in comparing the differences in the ?standard of living? between
countries at one point in time and over time.


[1] In both methods, the real (and not
nominal) value of GNI and GDP is estimated by taking into account the
inflation rates in the country and the United States in each year. A
three-year average of exchange rates adjusted for inflation using the
country?s GDP deflator is used to convert to the US dollar.

Michael A. Lebowitz
Professor Emeritus
Economics Department
Simon Fraser University
Burnaby, B.C., Canada V5A 1S6

Currently based in Venezuela. Can be reached at
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