Decoding PPP

Our first video spoke about the contrasting growth experiences of South Korea and India over time, and wondered why the experiences were so different.

We haven’t answered that question yet, although we shall begin to, in just a little while. But in order to understand the question itself better, we’ve put together a series of articles. The horizontal axis on the wealth and health chart compares GDP per capita, adjusted for inflation and adjusted for PPP. And compares this metric for many countries over 200 years.

What’s GDP, what’s inflation and what’s PPP? Three questions, requiring three separate blog posts. There’s one on understanding what GDP is all about, one on making sense of inflation, and now this one, on PPP.

PPP stands for Purchasing Power Parity. If inflation adjustment allows you to compare data across time, then PPP adjustment allows you to compare data across space. What exactly does this mean, and why is it necessary?

How many rupees will one dollar get you today? Or, to speak in the language of financial markets, what is the rupee-dollar exchange rate? Well, rounding off for convenience, it is about 65 rupees per dollar. Give me one dollar, and I’ll happily trade you around 65 rupees for it.

But, and here’s the important question, will one dollar in America buy me the same things that 65 rupees does in India? I can walk into a roadside barber shop in India and get a shave for roughly that amount. But a shave from a barber in America will quite easily cost ten times as much, maybe more – I’m informed that it is around ten dollars for a shave in America, excluding tips.

So yes, one dollar may trade for sixty five rupees, but these two amounts don’t purchase the same things in both countries. There isn’t, in other words, parity (sameness) in the purchasing power of sixty five rupees in India and one dollar in America.

And that’s a problem, right? Because if sixty five rupees buys for you rather more than does one dollar, then that exchange rate is slightly misleading. So what is to be done?

What economists do is the following: they come up with a basket of goodsFOOTNOTE: Footnote that is more or less the same across countries, and ask: how many units of local currency will be required to buy this basket? Let’s say it is x rupees to buy this basket of goods in India, and y dollars to buy it in America.

x/y then becomes the PPP adjusted exchange rate.

That’s the simple version, and the real story is rather more complicated, but this is what PPP is – ignore the exchange rate, and adjust for the purchasing power of the two currencies. What this allows you to do is compare GDP per capita numbers across countries – which is what Gapminder is showing us in that first video.

Advertisements

Making sense of Inflation

If you took a look at the video we put up the other day, you’ll have noticed that the horizontal axis on that video represented GDP per capita, adjusted for inflation, and adjusted for purchasing power parity. What is inflation, and what is PPP? In today’s blog post, we’ll try and address the first question, and leave PPP for another day.

How much would you expect to earn if you walked out of a post-graduate college in India in the early 1970’s? About 300 rupees per month would have been considered par for the course back then.

How much would you expect to earn if you walked out of a post-graduate college in India about ten years ago? About 30,000 rupees per month would be a reasonable ballpark estimate.

Now, does this mean that a post-grad from 2007 was a hundred times better, or a hundred times more productive than a post-grad from 1977? Short answer: no.

Similarly, if a dosa back in the day retailed for maybe a rupee, and a dosa today sets you back by say fifty bucks – it doesn’t necessarily mean that a dosa today is fifty times better than a dosa from way back when.

In both of these cases, it’s not that the modern person or the modern dosa has gotten better – it’s that the purchasing power of the rupee has gone down. A rupee would buy you far more in the 1970’s than it does today.

Well ok, how much weaker is the rupee today? Now, the answer to that question can only be given by the measurement of inflation. Inflation, it turns out, is a way to compare different eras. But as any cricket fan will tell you, it is one thing to say something like this, and it is quite another to actually and definitively do it.

Who is the better batsman? Gavaskar, or Sachin or Kohli? Gavaskar, I would argue, faced the most hostile bowling of the three, while Kohli has to contend with the best fielding units among the three. Sachin lasted the longest of the three, and arguably had to contend with more expectations than the others – and this could go on and on. Since they played in different eras, comparing them makes no sense.

But an economist can’t just throw up her hands and say it can’t be done. She must devise ways and means to compare the purchasing power of the rupee across time. And this is devilishly difficult to do for many reasons, but here are the three most important ones:

  1. The things you can buy with a rupee change dramatically over time. How many iPhones could a rupee purchase in 1970 is a stupid question, since there were no iPhones back then. You could purchase a laptop for 30,000 rupees in 2007 and you can purchase one for 30,000 rupees today. But they are simply not the same laptops. If you aren’t buying the same things, or if you are buying the same things, but of different quality, it makes measuring inflation much more difficult.
  2. Let’s say the price of a particular metal goes up by 200% in a year, but hardly anybody uses this metal. The purchasing power of the rupee has gone down in this particular case, but that doesn’t mean everybody is now poor, since hardly anybody purchased that metal in the first place. But if the price of petrol goes up by 200% – ah, now that’s another story altogether. The prices of nearly every single thing change over time, but they don’t change at the same rate, and not all things are equally important. We must keep this in mind when we measure inflation
  3. A teenaged girl living in a highrise apartment in Colaba is going to have a very different list of things she buys on a monthly basis compared to, say, a 60 year old landless laborer in a village in Chattisgarh. Not only are all things not equally important, but their importance changes based upon who is buying.

For these and many other reasons, trying to measure inflation is almost an exercise in impossibility. But then again, one can’t give up on it. Without some statistically acceptable way of measuring inflation, you simply wouldn’t be able to compare economic output (or GDP) across time.

Which is why measuring inflation is hard, but also important!

A simple way to think about GDP

The most important question to come out of the video we shared the other day was of course this one: why did South Korea grow so much faster than India?

 

But in order to answer that question, we first need to ask another. And this question is a very important one from a theoretical perspective. When we say South Korea grew faster, what exactly are we measuring? In other words, the growth of what, exactly?

 

There are many, many different sources for understanding more about GDP – its definitions, its measurement, and the data associated with GDP in an Indian context. We have a post up about this ourselves. But in this post, we aren’t going to cover any of these topics – we’re going to give you a simple way to think about what GDP is, exactly.

 

Here’s a question: do you remember how many marks you scored in your final math exam when you were in the fourth standard? Of course you don’t. But if I were to ask you your favorite memory of the time that you spent in the fourth standard, an answer is far more likely. And GDP, for a nation, is kind of like marks for a student. It is a very good way to objectively measure progress, but it is equally important to remember that just as marks aren’t all that a student’s life is about, GDP isn’t all that a country’s progress is about.

 

That being said however, measuring a country’s performance by measuring its economic output is the best we can do right now. This (measuring a country’s GDP) is important because it allows us to do three things:

 

  1. It allows us to settle, insofar as these questions can be settled, the issue of how much income we generated in one year (or one quarter, or one month)
  2. It allows us to find out how much more we produced compared to our own output in the previous year (or the previous quarter)
  3. It allows us to compare ourselves with what other nations have been up to in the same time period.

That is to say, it allows to be objective about our performance, and allows us to compare across time, and across space. Without us, and South Korea, and all other nations on this planet using more or less the same methodology to measure economic output, comparisons would be impossible.

 

So if you’ve always wondered what the big deal about GDP is, you are right, in a way. GDP is to a country as marks are to a student. Very important, and the most objective way to measure progress, but certainly not the be all and end all.

 

So all right, when we talk about growth, we’re talking about GDP growth. However, if you go back and take a look at the video, you’ll find that the horizontal axis is talking about GDP growth adjusted for inflation and purchasing power parity (PPP). We’ll be talking more about these concepts in our follow-up blog posts.