Purchasing Power Parities

It is well understood that international comparisons of GDP at market exchange rates are deceptive about real income disparities. The main reason is that some commodities are not internationally traded, thus removing the economic mechanism for attaining price parity across borders. The expectation is that poorer countries will have lower wage rates and (hence) lower prices of non-traded goods relative to traded ones. Thus the purchasing power parity (PPP) rate differs systematically from the nominal exchange rate. Measures of global poverty and inequality have long been based on PPPs rather than market or official exchange rates.

The prices at country level used to estimate PPPs come from the International Comparison Program (ICP). The lastest ICP round is for 2011. The new PPPs imply some dramatic revisions to price levels and real incomes across the world as compared to the prior 2005 round. This has important implications for many cross-country comparisons, including measures of poverty and inequality.

Without presuming that either round is better methodologically, my paper “An Exploration of the Changes in the ICP’s Global Economic Lanscape” tries to help the community of ICP users better understand the economic factors underlying the estimated changes in price levels across countries.

Differences in domestic inflation rates have played a role, as expected. Two other factors are identified. The excess sensitivity to changes in market exchange rates suggests that the PPPs may put higher weight on internationally traded goods than do domestic deflators.

Additionally, faster growing countries have seen a steeper rise in their PPP relative to market exchange rates; this can be explained by a tendency for wage increases in growing economies to lead to a higher price level.

Together these factors account for over 70% of the variance in PPP changes even ignoring methodological changes. However, an independent downward drift in price levels is also evident, concentrated in the ICP’s Asia region. A possible explanation lies in the Asia region’s greater success (relative to other regions) in removing urban bias in the price surveys.

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