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Relationship Between GDP and PPP

Relationship Between GDP and PPP

Post MBA entrance exams when you will face GD & PI and during this period, your information on current affairs will prove to be very handy, not only content wise but you will remain a confident personality.

Following article on “Relationship between GDP and PPP” should give insight  to you.

In April 2012, the International Monetary Fund (IMF) claimed that India had become the third largest economy in the world after the US and China; while in December 2017, the IMF again said that India is poised to become the fifth largest economy in 2018. Does it meant that in the past five years, India decelerated to become the sixth largest economy from being the third largest in 2012? The answer is No! Both the claims made by IMF were true. In 2012, India became the third largest economy in terms of GDP measured by Purchasing Power Parity (PPP) while India is poised to surpass the UK and become the fifth largest economy in 2018 in terms of GDP measured in nominal terms. 

GDP i.e. Gross Domestic Product, is the sum total of the value of all the final goods and services produced within the boundaries of a country in an accounting year. GDP is the most widespread concept used to calculate the national income. As per the Economic Survey, the GDP of India in the year 2017-18 is estimated to be INR 130 lakhs crore (130 trillion approx.) Similarly, the GDP of Japan was estimated to be JPY 535 trillion in the last quarter of 2017. But the GDPs of India and Japan cannot be compared because both the GDPs are mentioned in their respective currencies. Therefore, in order to allow the GDP comparisons of different nations, the respective GDPs must be converted into some common currency and for that matter, the USD is the most widespread currency for inter-country comparisons. In Dollar terms, the Japanese GDP was USD 4.884 trillion in 2017 while that of India was USD 2.65 trillion. 

Thus, the GDP measured in some common currency provides better picture for cross country comparisons instead of local currencies. When measured in local currencies, the difference between Japanese and Indian GDP was of about 400 trillion which narrowed to just a little more than 2 trillion when measured in the USD. This happened because of the difference in the exchange rate of INR and JPY with respect to the USD. The GDP measured in this fashion through market exchange rate is called as nominal GDP. However, the nominal GDP sometimes also fails to provide accurate picture in inter-country comparisons because inflation rate is different in different nations. In order to factor in the impact of difference in prices of goods and services, GDP is measured in terms of PPP exchange rate instead of market exchange rate.   

The purchasing power of USD in India and Japan will be different because of different price of different goods in different countries. The purchasing power of a currency refers to the amount of currency required to purchase a common basket of goods and services. Under the theory of purchasing power parity, the exchange rate of two currencies are adjusted in such a manner to bring them at par. In the economic theory, the PPP exchange rate of Currency A to Currency B is equal to the ratio of cost of goods X in country A to the cost of goods X in country B.

The nominal GDP of India is USD 2.65 trillion when measured in terms of exchange rate but when measured in terms of PPP, it shoots up to USD 10.656 trillion and becomes the third largest economy of the world. Similarly for Japan, nominal GDP is USD 4.84 trillion but shoots up to USD 5.45 trillion in terms of PPP. It means that purchasing power of USD is higher in India than in Japan. In other words, more amount of a good X can be purchased in India with a USD than in Japan. 

Thus, the GDP measured in terms of PPP is a better measures to compare the living standard in countries as it factors in the cost of living as well. According to the IMF, PPP is the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country. 

The Economist magazine uses ‘Big Mac’ index to calculate the PPP exchange rate. In this approach, it calculates PPP exchange rates based on the McDonald’s burgers that sells in nearly identical form in many countries around the world. If a burger is sold in India at INR60 and in the US at USD1, then the PPP exchange rate will be 1 USD = 60 INR. 

One of the main advantage PPP exchange rate over market based exchange rate is that PPP is much more stable than that of market rate but its calculation is cumbersome.      

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