BACKGROUND NOTE, 12 December 2011

The use of exchange rates in international income comparisons

Richard Webb
Economics Section

Introduction

International comparisons of income levels,  standards of living, and growth rates of gross domestic product (GDP), require the conversion of national currency values of these units into a common base.[1] The most straightforward way of doing this is to convert the values of GDP measured in national currencies into a common currency (usually the US dollar) using exchange rates. This method results in some countries apparently having a per capita income of US$2 a day (or less) and this figure is often cited as a measure of absolute poverty.[2] But it is virtually impossible for a person in a high-income country to live on US$2 a day just for food let alone acquire other components of living standards such as clothing, energy and shelter. This raises the question of the validity of using exchange rates-based data in international income comparisons. This Background Note examines this issue and describes another more defensible method.

International comparisons and exchange rates

The use of exchange rates to compare GDP levels has the merit of being relatively simple. However, this method assumes that price levels for goods and services are the same in all countries:

... the use of exchange rates can provide a misleading representation of the size of economies relative to each other because it is based on the assumption that price levels in countries are identical. In other words, using exchange rates implies that one dollar buys the same basket of goods and services in different countries. This is obviously an incorrect assumption, and it is especially erroneous for countries at different levels of development. Using exchange rates typically understates the size of lower-income economies because prices are lower in these economies, especially for nontradable goods and services.[3]

The use of exchange rates is also problematic because rates reflect numerous influences and not just differences in price levels:

If there were free trade, stable exchange rates, small transportation costs, and no market imperfections, the use of exchange rates to convert income measures from a national to a common currency would result in comparable estimates across countries. However, market imperfections exist, and it is generally agreed that conversion using exchange rates might be misleading. In theory, changes in exchange rates are caused by changes in relative price-levels between countries. In practice, however, exchange rates are also affected by capital flows, speculation and market intervention by governments or central banks. Thus, what one US$ buys in the US does not necessarily correspond with the amount of goods and services that one US$ converted into another currency (using the exchange rate) buys in another country.[4] 

Further:

... market exchange rates are particularly ill-suited for comparisons of living standards. This emerges from the fact that exchange rates tend to exhibit large swings over short periods of time, implying rapid shifts of living standards between countries which cannot possibly have occurred.[5]

The intuition that price levels for goods and services differ across countries and that exchange rates reflect factors other than just differences in price levels is supported by The Economist magazine’s Big Mac index (see Box).

Box: The Big Mac index

A well-known indicator of whether exchange rates are at their ‘correct’ levels is The Economist magazine’s Big Mac index. This index compares the costs in local currencies of buying a Big Mac, and uses these costs to determine whether or to what extent a country’s currency is undervalued or overvalued relative to the US dollar. According to this measure, as of 25 July 2011, the Australian dollar was overvalued against the US dollar.

Source: The Economist, ‘The Big Mac index. Currency comparisons, to go’, The Economist on line, viewed 8 December 2011, http://www.economist.com/blogs/dailychart/2011/07/big-mac-index

Purchasing power parities

Purchasing power parities (PPPs) are a method of making international comparisons that seek to avoid the shortcomings of using exchange rates to measure differences in income levels across countries. PPPs are:

… price relatives. In their simplest form they show the ratio of prices in national currencies of the same precisely-defined product in different countries. For example, if the price of a kilo of oranges of a specified quality is 45 rupees in country A and 3 dollars in country B, the PPP for such oranges between the two countries, when B is the base country, is the ratio 45 to 3 or 15 rupees to the dollar. In other words, for every dollar spent on oranges of the specified quality in country B, 15 rupees would have to be spent in country A to obtain the same quantity and quality of oranges.[6]

PPPs compare the values of a given bundle of goods and services across countries taking into account the actual prices of each component of the bundle.[7] The Organisation for Economic Co-operation and Development, for example, uses a bundle of about 3000 goods and services in its PPPs calculations.[8]  Such comparisons inevitably give rise to difficulties. They include determining the composition of the goods and services in the bundle, and the measurement of prices. PPPs calculations are affected by different goods and different consumption patterns.

Purchasing power parities and exchange rates

Comparisons of PPPs-based data with exchange rate data can yield quite different results. They include:

•        there can be marked differences in the size of economies in GDP comparisons

•        exchange rates-based measures generally understate  volumes of GDP and income in international comparisons, and

•        the gap between high-income and low-income countries narrows when PPPs are used instead of exchange rates.[9]

The use of exchange rates rather than PPPs was an issue in the Intergovernmental Panel on Climate Change’s (IPCC) Special Report on Emissions Scenarios (SRES).[10] The IPCC used mainly market exchange rates (MERs) to convert national GDP data to a common base. Some economists and statisticians challenged the IPCC’s methodology.[11] The House of Lords Select Committee on Economic Affairs reviewed the ensuing debate finding ‘no support for the use of MER in such exercises’ other than from a member of the IPCC.[12]

Conclusions

Measures of income levels and living standards based on exchange rates can be very misleading. While the measurement of PPPs has its own set of problems, PPPs avoid the obviously wrong assumptions that price levels are the same across all countries by using actual prices, and that exchange rates reflect only or primarily the relative purchasing powers of currencies in their national markets. PPPs are therefore to be preferred to exchange rates measures.

It is precisely because exchange rate-base comparisons can be misleading that the World Bank embarked on its international comparison program. This is:

... a worldwide statistical partnership to collect comparative price data and compile expenditure values of countries’ gross domestic products (GDP) and to estimate purchasing power parities (PPPs) of the world’s economies. Using PPPs instead of market exchange rates to convert currencies makes it possible to compare the output of economies and the welfare of their inhabitants in real terms (that is, controlling for difference in price levels).[13]

In addition to the World Bank, a number of organisations use PPPs to make cross-country comparisons. The OECD’s calculations of PPPs include those for Australia as well as other OECD countries.[14]

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[1].               The Organisation for Economic Co-operation and Development (OECD) defines gross domestic product as an aggregate measure of production equal to the sum of the gross values added of all resident institutional units engaged in production (plus any taxes, and minus any subsidies, on products not included in the value of their outputs). The sum of the final uses of goods and services (all uses except intermediate consumption) measured in purchasers’ prices, less the value of imports of goods and services, or the sum of primary incomes distributed by resident producer units. See OECD, ‘Glossary of statistical terms’, OECD website, viewed 5 December 2011, http://stats.oecd.org/glossary/detail.asp?ID=1163

[2].               See, for example, Y Zaw, ‘Young Aussies to live on $2 a day for good cause’, The West Australian, 10 May 2011, viewed 5 December 2011, http://au.news.yahoo.com/thewest/a/-/wa/9345508/young-aussies-to-live-on-2-a-day-for-good-cause/

[3].               The Conference Board Incorporated, ‘Purchasing power parities and size of GDP’, Conference Board website, viewed 5 December 2011, http://www.conference-board.org/attach/PurchasingPowerParities_GDP.pdf

[4].               World Bank, ‘Estimating comparable income numbers using exchange rates’, World Bank website, viewed 5 December 2011, http://web.worldbank.org/WBSITE/EXTERNAL/DATASTATISTICS/EXTDECSTAMAN/0,,print:Y~isCURL:Y~contentMDK:20877885~pagePK:64168427~piPK:64168435~theSitePK:2077967~isCURL:Y~isCURL:Y,00.html

[5].               P Schreyer and F Koechlin, Purchasing power parities-measurement and uses, Statistics Brief, March 2002, OECD website, viewed 5 December, 2011, http://www.oecd.org/dataoecd/32/34/2078177.pdf

[6].               World Bank, ‘What are PPPs?’, World Bank website, viewed 5 December 2011, http://web.worldbank.org/WBSITE/EXTERNAL/DATASTATISTICS/ICPEXT/0,,contentMDK:22390971~menuPK:6747859~pagePK:60002244~piPK:62002388~theSitePK:270065,00.html

[7].               For a fuller description of how PPPs are calculated, see ibid. 

[8].               OECD, New comparison of GDP and consumption based on purchasing power parities for the year 2005, media release, Paris, 21 November 2007, viewed 5 December 2011, http://www.oecd.org/dataoecd/53/47/39653689.pdf

[9].               P Schreyer and F Koechlin, op. cit.

[10].               Intergovernmental Panel on Climate Change, IPCC special report. Emissions scenarios. Summary for policymakers, 2000, viewed 5 December 2011, http://www.ipcc.ch/pdf/special-reports/spm/sres-en.pdf

[11].               See, for example, W Nordhaus, ‘Alternative measures of output in global economic-environmental models: purchasing power parity or market exchange rates?’, Energy Economics, vol. 29, 2007, pp. 349-372, viewed 5 December 2011, http://nordhaus.econ.yale.edu/ppp_wdn_enecon_2007.pdf

[12].               House of Lords Select Committee on Economic Affairs, The Economics of climate change, vol. 1: report, 6 July 2005, pp. 33-34, viewed 5 December 2011, http://www.publications.parliament.uk/pa/ld200506/ldselect/ldeconaf/12/12i.pdf

[13].               World Bank, ‘International Comparison program’, World Bank website, viewed 5 December 2001, http://siteresources.worldbank.org/ICPEXT/Resources/ICP_2011.html

[14].               OECD, ‘Purchasing power parities (PPPs) data’, OECD website, viewed 8 December 2011, http://www.oecd.org/document/47/0,3746,en_2649_34357_36202863_1_1_1_1,00.html 