Saturday, June 12, 2004

Purchasing Power Parity

Over- or under- anything, such as overvalued or undervalued, evoke the old question: compared to what?

The Economist of May 29th asks: "How big is the world economy? That sounds like a straightforward question. Simply add up the size of the world's national economies would seem to be the obvious way to answer it. But how that is done yields radically different results, and therein lies a tale. The most commonly used method is to convert national economic outputs to a single measure, namely the American dollar, using the market exchange rates of all national currencies." Use purchasing power parity (PPP) conversions, instead, and the world economy grows from $36 trillion to $50 trillion.

Moreover, the Intergovernmental Panel on Climate change projects implausibly high future carbon emissions based on heroic growth assumptions for the poor countries -- and values their future GDP in U.S. dollars.

What to do? Trust market rates or PPP? No one has gotten rich using PPP as a guide to currency speculation. Do markets include knowledge (beliefs) that PPP misses? Apparently so; otherwise there would be no discussion.

The comparisons are, perhaps, interesting but it is unclear that are clear signals for personal or policy actions.