Thursday, February 03, 2011

GDP Comparisons-Current Exchange Rates Or PPP?

I have recently pointed out that Egypt's GDP is smaller than that of Israel and Finland-which is anything but impressive given the fact that its population is more than 10 times bigger than Israel's and nearly 15 times bigger than Finland's.

Yet estimates of purchasing power parity (PPP) adjusted per capita income "only" shows that Israel's per capita income is 4 to 5 times higher and Finland's 5 to 6 times higher (as estimates of the PPP of currencies differs, estimates of PPP-adjusted per capita income also differs).

The explanation for this divergence is the co-called Penn effect or Balassa-Samuelsson effect, which means that the general price level is higher in high income countries, meaning that the difference in PPP-adjusted income tends to be lower than income differences using current exchange rates.

But what is most relevant-income differences at current exchange rates or income differences adjusted for PPP?

That depends on the context. In the context that I discussed, namely the effects of the unrest in Egypt on the world economy, than current exchange rates should be used. The reason is that when dealing with the outside world, income in Egyptian pounds can only buy things using current exchange rates. It doesn't really matter whether or not domestic purchasing power is higher or lower, it only matters what purchasing power in foreign transactions it has. Which is why Egypt's direct importance in the world economy is smaller than Israel's or Finland's.

However, in other contexts, such as discussions of differences in living standards, it is the PPP-adjusted values that are more relevant. If you for example donät have to pay much rent and if food and other stuff you buy is cheap, then you will have a much higher standard of living than someone with the same income who has to pay a high rent and pay high prices for food and other things that person buys. That is why PPP-adjustment is in principle (In practice, the fact that estimates vary however means that you should analyze them with an extra grain of salt) better in the context of analyzing living standards and poverty. And that is why Egyptians aren't 15 times poorer than Finns.

Note that the latter doesn't just apply to analysis of different countries, it also applies when analyzing income differencies between different regions and localities within a country. One example of this that I recently discussed was the cases of California and Texas.

No PPP-estimates for American states exists as far as I know, but it seems very likely that the seemingly somewhat higher average income in California  reflects entirely or more a higher cost of living in general and a higher cost of housing in particular, rather than a higher real income of Californians compared to Texans.