How We Make Intertemporal and International Comparisons

How can the performance of the US economy be compared to that of other countries? Is the US the wealthiest country, or has it lost its leadership to Japan or Germany? Is it true that per capita income produced in Ethiopia in one year equals the income produced in just two days in the US? Unfortunately, these questions turn out to be deceptively difficult. While accounting standards have been generally agreed upon, international comparisons remain a trouble spot.

The first step would be to generate the GDP per capita data. It is irrelevant that India's GDP is more than twice the size of Austria's since India has a population that is 110 times that of Austria. What matters more is GDP per capita, which is obtained by simply dividing the GDP by the population figures. When we do this, a very different picture emerges.  We find that the value of output per person in Austria is 50 times higher than that in India.

But how do we make the comparison across countries when each country has its own currency? We must develop a common denominator, a yardstick that can be used to measure all of the countries. The easiest conversion to a 'common yardstick' would be to convert each output figure to dollars by using the exchange rate. For example if GDP per capita in Japan is 2,000,000 yen and the current US$ exchange rate is 100 yen, then GDP per capita in Japan would be $20,000 [2,000,000/100].

The rationale for this conversion is that a dollar buys the same amount of goods in the US as in another country, but anyone who has traveled knows that it doesn't. The reason is that the price of many goods, including housing and services such as legal aid and education, can vary substantially between countries, just as they can between regions.  The problem is exchange rates do not reflect differences in buying power associated with price differentials.  This is referred to as purchasing power parity. The price of a house in San Francisco in 1991 was 4 times higher than the price in Louisville, KY and it would be unreasonable to assume that someone with an income of $50,000 would have the same buying power or lifestyle in the two cities.

When we take into account purchasing power differences, international rankings can be substantially affected. The purchasing power parity (PPP) measures constructed by Sommers and Heston, known as the Penn World Tables, were designed to account for this issue. The PPP basis is defined as: "The goods and services produced in different countries should be valued consistently if the differences observed are meant to reflect real differences in the volumes of goods and services produced. The use of purchasing power parities (PPP) instead of exchange rates is intended to achieve this objective. PPPs show how many units of currency are needed in one country to buy the same amount of goods and services which one unit of currency will buy in the other country."

The differences can be dramatic. Turkey's economy is one - quarter the size of Japan if we use the PPP method, but only one-tenth the size if we use the exchange rate method.  Mexico, meanwhile is nearly thirty percent of the size of the US economy if the PPP method is used, substantially higher than the twelve percent figure when the exchange rate method is used. For those who like to keep score, you will also note that the relative ranking of Japan and the US depends upon the method adopted. If we accept the PPP method, then per capita GDP in the US is substantially above that in Japan, but if we accept the exchange rate method, Japan comes out on top. To test your mastery of the table, you should attempt to explain the flip-flop as we compare the US and Japan using the two measures. The PPP measure reflects the fact that when an American with $s travels to Japan the $ do not seem to buy as much.

Alternative GDP Measures

(1994 billion $s)

OECD data from the Statistical Abstract of the United States 1996