Macroeconomics (1)

The Construction of PPP Numbers
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Consider two countries—let’s call them the United States
and Russia, although we are not attempting to fit the characteristics
of those two countries very closely:
In the United States, annual consumption per person
equals $20,000. People in the United States each buy two
goods: Every year, they buy a new car for $10,000 and
spend the rest on food. The price of a yearly bundle of food
in the United States is $10,000.
In Russia, annual consumption per person equals
60,000 rubles. People there keep their cars for 15 years.
The price of a car is 300,000 rubles, so individuals spend
on average 20,000 rubles—300,000/15—a year on cars.
They buy the same yearly bundle of food as their U.S.
counterparts, at a price of 40,000 rubles.
Russian and U.S. cars are of identical quality, and so
are Russian and U.S. food. (You may dispute the realism of
these assumptions. Whether a car in country X is the same
as a car in country Y is very much the type of problem confronting
economists when constructing PPP measures.)
The exchange rate is such that one dollar is equal to 30 rubles.
What is consumption per person in Russia relative to
consumption per person in the United States?
One way to answer is by taking consumption per person
in Russia and converting it into dollars using the exchange
rate. Using this method, Russian consumption per
person in dollars is $2,000 (60,000 rubles divided by the
exchange rate, 30 rubles to the dollar). According to these
numbers, consumption per person in Russia is only 10% of
U.S. consumption per person.
Does this answer make sense? True, Russians are
poorer, but food is much cheaper in Russia. A U.S. consumer
spending all of his 20,000 dollars on food would
buy 2 bundles of food ($20,000/$10,000). A Russian consumer
spending all of his 60,000 rubles on food would
buy 1.5 bundles of food (60,000 rubles/40,000 rubles). In
terms of food bundles, the difference looks much smaller
between U.S. and Russian consumption per person. And
given that one-half of consumption in the United States
and two-thirds of consumption in Russia go to spending
on food, this seems like a relevant computation.
Can we improve on our initial answer? Yes. One way
is to use the same set of prices for both countries and
then measure the quantities of each good consumed
in each country using this common set of prices. Suppose
we use U.S. prices. In terms of U.S. prices, annual
consumption per person in the United States is
obviously still $20,000. What is it in Russia? Every year,
the average Russian buys approximately 0.07 car (one
car every fifteen years) and one bundle of food. Using
U.S. prices—specifically, $10,000 for a car and $10,000 for
a bundle of food—gives Russian consumption per person
as [10.07 : $10,0002 11 : $10,0002 ] [$ 700
$10,000] $10,700. So, using U.S. prices to compute
consumption in both countries puts annual Russian consumption
per person at $10,700>$ 20,000 53.5% of annual
U.S. consumption per person, a better estimate of
relative standards of living than we obtained using our
first method (which put the number at only 10%).
This type of computation, namely the construction of
variables across countries using a common set of prices,
underlies PPP estimates. Rather than using U.S. dollar
prices as in our example (why use U.S. rather than Russian
or, for that matter, French prices?), these estimates use
average prices across countries. These average prices are
called international dollar prices. Many of the estimates
we use in this chapter are the result of an ambitious project
known as the “Penn World Tables.” (Penn stands for the
University of Pennsylvania, where the project is located.)
Led by three economists—Irving Kravis, Robert Summers,
and Alan Heston—over the course of more than 40 years,
researchers working on the project have constructed PPP
series not only for consumption (as we just did in our example),
but more generally for GDP and its components,
going back to 1950, for most countries in the world.
For more on the construction of PPP numbers, go
to the Web site http://pwt.econ.upenn.edu/ associated
with the Penn World Tables. (In the Penn tables, what
is the ratio of Russian PPP GDP per person to U.S. PPP
GDP per person?) The IMF and the World Bank also
construct their own set of PPP numbers.
When comparing rich versus poor countries, the differences between PPP numbers
and the numbers based on current exchange rates can be very large. Return to
the comparison between India and the United States. We saw that, at current exchange
rates, the ratio of GDP per person in the United States to GDP per person in India was
36. Using PPP numbers, the ratio is “only” 14. Although this is still a large difference,
it is much smaller than the ratio we obtained using current exchange rates. Differences
between PPP numbers and numbers based on current exchange rate are typically
smaller when making comparisons among rich countries. If we were to compare
using current exchange rates—GDP per person in the United States in 2010 was equal
to 115% of the GDP per person in Germany. Based on PPP numbers, GDP per person
210 The Long Run The Core