Chandrasekhar and Ghosh – Purchasing Power Parity
A popular way of comparing per capita GDP across countries is the use of deflators based not on nominal exchange rates but on Purchasing Power Parity (PPP) exchange rates that seek to establish the relative purchasing power of each currency in terms of prices of a common basket of commodities. This has become the preferred way of comparing cross-country incomes and even poverty within countries, in much of the international discussion.
However, the use of PPP exchange rates can be quite dubious, as they are based on prices of a basket of average representative consumption goods in the United States, which may not be so relevant to consumption elsewhere, especially the poor in much of the developing world. They are unchanging over time, even though consumption patterns tend to shift with technological change and evolving preferences. PPP exchange rates are also notoriously imperfect because of the infrequency and unsystematic nature of the price surveys that are used to derive them, which can make them quite dated or even misleading.
There is a less talked about but possibly even more significant conceptual problem with using PPP estimates. In general, countries that have high PPP, that is where the actual purchasing power of the currency is deemed to be much higher than the nominal value, are typically low-income countries with low average wages. It is precisely because there is a significant section of the workforce that receives very low remuneration, that goods and services are available more cheaply than in countries where the majority of workers receive higher wages. Therefore, using PPP-modified GDP data may miss the point, by seeing as an advantage the very feature that reflects greater poverty of the majority of wage earners in an economy.
There is another concern: that the use of PPP estimates may also be misleading because in effect the World Bank tends to use a simple multiple to derive the data across a long period of years, on the basis of a price survey for a particular year, without considering the significant volatility in prices that may affect genuine purchasing power. This is particularly the case with respect to China and India, two countries for which the PPP data have fluctuated wildly over time depending upon the changing nature of price surveys and other factors.
Commentary added 8th April 2015