Gross Domestic Product and Purchasing Power Parity are terms used to determine the economic growth of a country. GDP is the overall performance of a country over a period of time. PPP, on the other hand, determines the performance after including factors such as inflation and currency exchange rates. This article explains GDP and PPP in brief.
What is GDP?
GDP stands for Gross Domestic Product. It is the total value of everything produced in the country by citizens as well as foreigners. It is counted as long as it is located inside the country boundary. To prevent double-counting, GDP considers only the final value of the product. It does not consider the parts that go into it. For example, the end product car is considered in the calculation of GDP. However, its individual parts are not considered.
GDP consists of the following components:
1) Personal consumption expenditures. (C)
2) Business investment (I)
3) Government spending (G)
4) Exports (X) and imports (M)
It is calculated by the following formula:
GDP = C + I + G + (X-M)
GDP refers to the “size” of an economy of a country. It impacts the personal finance, investment, and job growth. Investors observe a country’s growth rate to decide if they should adjust their asset allocation. They also compare the growth rates of countries to find their best international opportunities. They buy shares of companies present in rapidly growing countries.
What is PPP?
PPP stands for Purchasing Power Parity. It is an economic theory that compares currencies from different countries through a “basket of goods” approach. According to this principle, two currencies are in balance when a basket of goods (taking into account exchange rate) is valued the same in both countries.
In order to compare prices across countries meaningfully, we need to consider a range of goods and services. The amount of data that needs to be considered for such a scenario is huge and complex. To facilitate this, the International Comparison Program (ICP) was established in 1968 by the University of Pennsylvania and the United Nations. Purchasing power parities generated by the ICP are based on worldwide price survey comparing the prices of hundreds of various goods. This data helps international macroeconomists to come up with estimates of global productivity and growth.
We can use PPPs as an alternative to market exchange rates. The actual purchasing power of any currency is the amount of that currency needed to buy a definite unit of a good or a basket of common goods and services. The purchasing power of every country is calculated based on its relative cost of living and inflation rates. Purchasing power plus parity equalizes the purchasing power of two different currencies by accounting for differences in inflation rates and cost of living.
Difference between nominal GDP and PPP GDP
GDP (Gross Domestic Product) is the total market value of all final goods and services manufactured in a country in a given period. All countries report their data in their own currency. To compare the data, every country’s currency needs to be converted into a common currency. There are mainly two methods to do this: nominal and purchasing power parity (PPP).
Nominal GDP determines the performance of a country as a whole. It can also help make international comparisons. In this method, we use market exchange rates for conversion. However, in this method, we don’t consider differences in the cost of living in various countries.
PPP is more useful when you want to compare differences in living standards between nations. For example, a cup of tea is more expensive in the USA than in India. In PPP, the currency of one country is converted to another country in order to purchase the same volumes of goods and services. PPP exchange rates are relatively stable over time.
The top five countries with the highest GDP in market exchange terms are the USA, China, India, Japan and Germany. The names change when we use PPP. In 2017, according to data from the International Monetary Fund (IMF), China is now the world’s largest economy based on purchasing power parity with 23,122 billion current international dollars. The USA is second with 19, 382 billion. It is followed by India, Japan and Germany with 9,447 billion, 5,405 billion and 4,150 billion respectively.