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Key Statistics - article, July 2003, p. 9-12
Purchasing power parities (PPPs) are conversion rates that equalise the purchasing power of different currencies by eliminating the differences in price levels between countries. PPPs are the most suitable measure of international standard-of-living comparisons because they reflect just the differences in the volume of goods and services produced. This article explains what PPPs are, and why they are a better measure than exchange rates for international comparisons of GDP. It provides details of the data requirements, product selections and summary results for the 1999 round of the Eurostat-OECD PPP Programme.
Purchasing Power Parities1
Introduction
The Eurostat-OECD Purchasing Power Parity Programme was established in the early 1980s to provide internationally comparable price and volume measures of GDP (gross domestic product) for members of the European Union, the OECD, and thirteen other countries. The 1999 round is the sixth and most recent round of the programme, covering 43 countries.
International comparisons of GDP
GDP per capita is the measure most frequently used to represent the economic well-being of a country’s residents. International volume comparisons of GDP depend on three conditions:
- That the definition of GDP is the same.
- That the currency unit in which GDP is expressed is the same.
- That the price level at which GDP is valued is the same.
Therefore, it is necessary to have conversion rates that act as both a currency convertor and a price deflator.
Purchasing power parities
The conversion rate outlined above is a purchasing power parity (PPP). It is the rate which equalises the purchasing power of different currencies by eliminating the differences in price levels between countries.
In simpler terms, when the GDPs of countries are converted to a common currency using PPPs, they are also revalued at a common set of prices. Consequently, they reflect only differences in the volumes of goods and services produced in the countries, and are real measures.
Exchange rates
Before PPPs became available, exchange rates had to be used to make international comparisons of GDP. While GDPs were all expressed in a common currency, the exchange rate measure did not equalise price levels. GDP was still valued at national prices, and was therefore a nominal measure.
Exchange rate converted data are generally misleading because they will overstate the size of economies with relatively high price levels and understate the size of economies with relatively low price levels.
Another problem is that exchange rates are subject to violent fluctuations. This means that a country will suddenly appear to become ‘richer’ or ‘poorer’ even though there has been little or no change in the relative volumes of goods and services produced.
Furthermore, exchange rates do not reflect the relative price of domestically produced goods and services. Instead, they reflect the relative price of tradeable goods, and factors such as interest rates.
Purchasing power parities are the most suitable measure for comparing GDP across countries. They ensure that GDPs are not only valued using a common currency, but also at a common set of prices.
In their simplest form, PPPs are nothing more than price relatives. For example, if the price of a hamburger is 1.65 dollars in New Zealand and 0.75 pounds in Great Britain, then the PPP for hamburgers between New Zealand and Great Britain is 2.2 dollars to the pound. This means that for every pound spent on hamburgers in Great Britain, 2.20 dollars would have to be spent in New Zealand to obtain the same quantity and quality, ie the same volume, of hamburgers.
Basic data requirements
Under the Eurostat-OECD PPP Programme, the calculation of PPPs requires each country to provide a set of national annual prices, and also a breakdown of national expenditures. The prices should be for a selection of products chosen from a basket of goods and services covering the whole range of goods and services that make up GDP.
The prices are used to derive price relatives at the product level and then PPPs at the product group level, while the expenditures are used as weights with which to obtain PPPs.
The prices supplied by countries need to meet three conditions:
- They must be for items that are representative of their final expenditure on GDP.
- They must be for items that are comparable between countries.
- They must be consistent with the methods of valuation used to estimate the expenditures.
- In most cases, the prices will be market transaction prices, paid by purchasers.
Classification of expenditures
The framework for the comparison comes from final expenditure on GDP, broken down into product groups. For the 1999 comparison, GDP was broken down into seven main aggregates, 27 expenditure categories, 69 expenditure groups, 154 expenditure classes and 221 basic headings. This expenditure breakdown is based on the classification of final expenditure on GDP of the System of National Accounts (SNA) 1993.
In principle, a basic heading consists of a group of similar goods or services for which a sample of products can be selected that are both representative of their type and of the purchases made in participating countries. In practice, a basic heading is defined by the lowest level of final expenditure for which explicit expenditure weights can be estimated. Therefore, a basic heading can cover a broader range of goods and services than is theoretically desirable.
Product selection
The product lists were established by Eurostat and the OECD, in consultation with participating countries. It was important that the product lists were ‘equally’ representative across countries. To achieve this, for every basic heading, each country was asked to nominate and define at least one product that it considered to be ‘representative’. Care was taken to ensure that the products selected for the basket were commonly found in as many participating countries as possible. However, it was not necessary for all countries to price all products in the basket.
The number of products selected for a basic heading varied from less than five to more than 50. It was dependent on a number of factors, including the heterogeneity of the products covered by the basic heading, the availability of common representative products across countries and the importance of the basic heading as measured by its expenditure weight.
Product specification
Each product selected was defined by a product specification to ensure that each country priced equivalent or comparable items. In practice, it wasn’t possible to have all specifications brandand model-specific. This meant that some variability in quality between the products occurred. Prices were not adjusted by the OECD, but the data was rigorously edited. Countries were asked about apparent discrepancies and corrected price data were supplied in most cases.
The final product lists for the 1999 comparison covered around 2,500 consumer goods and services, 34 occupations in government, health and education services, 186 types of equipment goods and 20 construction projects.
Summary results for 1999
Figure 1 displays GDP per capita results for the seven non-European and the OECD countries (Australia, Canada, Japan, Korea, Mexico, New Zealand, United States), the EURO 12 and the United Kingdom. The indices are based on the OECD 30 (=100).
Figure 1 emphasises that GDP per capita based on exchange rates can be a misleading indicator of a country’s economic well-being. As value measures, they do not take into account the price level differences between countries. For example, Japan’s exchange-rate based GDP per capita is 68 percent higher than Canada’s. However, when price level differences between the two countries are taken into account, Canada’s PPP-based GDP per capita is actually 6 percent higher than Japan’s. This is a reflection of Canada’s having a much lower price level than Japan. Figure 1 clearly shows that the United States has a higher level of economic well-being than the other selected countries, when they are compared on the basis of PPPs.
New Zealand’s exchange-rate-based GDP per capita index is 64. However, our PPP-based GDP per capita index is boosted to 83, an improvement of 30 percent. This is because New Zealand also has a relatively low price level in comparison with other OECD countries.
The indices of PPP-based GDP per capita provide only an indication of the relative order of economic well-being in a particular country in comparison with others. Therefore, rather than ranking countries strictly, it is better to use the indices to assign countries to groups, although this does involve a certain degree of arbitrariness. According to PPP-based GDP per capita, the 43 countries can be assigned to four groups as follows: a high income group (120 and above, a high-middle income group (between 100 and 119), a low-middle income group (between 50 and 99), and a low income group (less than 50).
The countries can also be divided into four groups based on their comparative price levels: a high price level group (110 and above); a medium-high price level group (between 90 and 109); a medium-low price level group: (between 60 and 89); and a low price level group (less than 60).
The composition of the price level groups and the income groups are almost the same, though Japan, Sweden and Mexico are in price level groups higher than their income groups and Luxembourg, the United States, Italy, Australia, Canada, Hungary, the Czech Republic and the Slovak Republic are in price level groups lower than their income groups. The similarities of the two groups is further evidence that income levels and price levels are positively correlated between the two countries.
Figure 2 supplements figure 1 by displaying GDP per capita volume indices and comparative price levels for the same set of countries. Any country with a comparative price level of less than 100 will have a higher level of real GDP than nominal GDP. As mentioned above, Canada is an example of this occurring, with its nominal GDP per capita index of 94 boosted to a real index of 117. The country with the lowest price level is Mexico. Its nominal GDP per capita index of 22 is raised to a real index of 37. This is an improvement of 68 percent.
Japan provides the counter-example, as its nominal GDP per capita index of 158 falls to a real index of 110, a downgrade of 30 percent. This is due to its extremely high comparative price level index of 143, where the OECD 30 average equals 100.
Figure 2 shows that, in general, countries with a lower real GDP per capita also have a lower price level. This implies that the measures of real GDP per capita bring the richer and poorer countries closer together than the measures of nominal GDP per capita.
New Zealand has a comparative price level index of 77 and a real GDP per capita index of 83. This real GDP per capita index ranks it 23rd of the 43 countries, directly below Spain and directly above Portugal.
As part of the summary results, Eurostat-OECD have compiled a cross-country comparison of price levels for final expenditure on GDP. The results are presented in two sections; firstly, according to the classifications of final expenditure in the 1993 SNA (System of National Accounts); and secondly, according to classifications of final expenditure by type of product. The data can be exchange rate adjusted, so that price level comparisons under a common currency can be made.
Focusing on NZ-United States comparisons, for every unit of currency spent in the United States on actual individual consumption, 0.74 units of currency would have to be spent in New Zealand to obtain the same quantity and quality (ie the same volume) of actual individual consumption.
The NZ-US comparative price levels under the SNA classification range from 0.40 (education) to 1.12 (clothing and footwear). In New Zealand, education, health and communication are the relatively cheapest final expenditure categories. This is no doubt aided by the fact that education and health are largely State-provided in this country. For every unit of currency spent on domestic GDP in the United States, 0.76 units of that same currency must be spent in New Zealand to obtain the same volume of goods and services.
The price level comparison between New Zealand and Australia indicates that we are on a similar level to our neighbours. Price levels in New Zealand, per unit of expenditure in Australia, range from 0.70 for restaurants and hotels to 1.24 for construction. For every unit of currency spent on domestic GDP in Australia, 0.90 units of that same currency must be spent in New Zealand to obtain the same volume of goods and services.
The NZ-United Kingdom comparisons follow the same broad trends as the previous two. Namely, New Zealanders spend relatively less on education, communication and in restaurants and hotels to obtain the same volume of goods and services. In all three cross-country comparisons, services are cheaper in New Zealand than goods.
The more expensive categories are construction, clothing and footwear, and household furnishings, equipment and maintenance.
An interesting sidelight is that net purchases abroad and the balance of exports and imports are equivalent to 1.00 in all three comparisons mentioned above. By convention, relative export and import prices are measured by exchange rates. The justification for this is that they are traded on world markets where international competition leads to a convergence of relative prices and exchange rates. Therefore, when expressed in terms of relative prices, a comparative price level of 1.00 must be recorded for trade flows.
Future PPP results
The seventh round of the PPP programme uses 2002 as the benchmark year. The results will not be published until 2004. In the meantime, the 1999 results continue to be updated, based on revisions that countries have made to their estimates of GDP and mid-year population since the last update. Therefore, the indices of real GDP per capita can change from one update to the next.
Further information
For further information on the PPP programme carried out by the OECD and its member countries, see http://www.oecd.org/std/ppp. For an overview of uses and interpretation of PPPs, see “Statistics Brief” http://www.oecd.org/pdf/M00027000/M00027819.
Footnote
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