Purchasing Power Parity (PPP) plays a crucial role in comparing the real value of currencies and economic output across nations. Unlike nominal GDP, which relies on market exchange rates, PPP takes into account the cost of living and purchasing ability in each country.
This article explores how PPP redefines the understanding of India’s economy and its position in the global landscape, while also explaining the methodology and implications of PPP-based analysis.
India’s Economic Size In PPP Terms
- PPP Valuation of the Indian Economy: NITI Aayog Vice-Chairman Suman Bery recently stated that India’s economy, when evaluated using Purchasing Power Parity, stands at $15 trillion. This estimate places it at more than half the size of the United States economy.
- Market Price Versus PPP Estimates: India’s GDP at market prices is valued at $4 trillion. However, when adjusted for PPP, it reveals an economic size of $15 trillion. This significant difference highlights how PPP provides a more realistic perspective on economic output.
- Comparison with the United States: The United States, under PPP metrics, holds a $29 trillion economy. In this context, India’s $15 trillion economy represents approximately half the scale of the American economy.
Role Of IMF And ICP In PPP Estimates
- Use of PPP in International GDP Comparison: The International Monetary Fund (IMF) relies on PPP-based GDP estimates to facilitate meaningful cross-country comparisons. These estimates are produced by the International Comparison Program (ICP).
- Function of the International Comparison Program: The ICP is a global statistical initiative responsible for generating internationally comparable PPP estimates. It provides the foundation for evaluating global economies beyond market exchange rates.
- India’s Global Rank Since 2009: Based on PPP-adjusted GDP, India was recognized as the third-largest economy as early as 2009. This ranking has remained consistent in subsequent assessments.
International Comparison Program (ICP)
The ICP is a worldwide statistical initiative responsible for collecting price data and GDP expenditure information for computing PPP across countries.
Leadership and Oversight: It is coordinated by the World Bank and operates under the guidance of the United Nations Statistical Commission.
Established and Evolving: Founded in 1968, the ICP became a permanent part of global statistical efforts in 2016.
Additional Outputs: Besides PPP, the ICP also produces the Price Level Index (PLI), which is the ratio of PPP to the actual exchange rate.
Latest Global Purchasing Power Parities (PPPs) Report
The International Comparison Program (ICP), as reported by the World Bank, released its most recent data on global purchasing power parities (PPPs) in May 2024. This release covers multiple datasets including information for the reference year 2021, updated figures for 2017, PPP time series spanning 2018 to 2020, and projected GDP PPPs for 2022 and 2023.
The ICP 2021 cycle results were finalized by April 2024 and officially presented to the heads of national implementing agencies, receiving endorsement from the Regional Advisory Board.
Key Highlights
- China emerged as the largest economy in 2021 with a GDP of $28.8 trillion based on PPP, followed by the United States.
- India ranked third with an economy valued at $11.0 trillion, representing 7.2% of the global GDP.
- High-income countries, although home to only 16.4% of the world’s population, contributed 46% of the global GDP.
- Conversely, low-income countries accounted for 8.4% of the global population but contributed merely 1% of the global GDP.
Methodology Of Purchasing Power Parity
What Is Purchasing Power Parity?
Purchasing Power Parity is a macroeconomic concept used to assess economic productivity and living standards across countries. It compares currencies based on the amount required to buy the same basket of goods in different nations.
Equilibrium in Currency Values
According to PPP theory, two currencies are considered at equilibrium when a basket of identical goods has the same price in both countries after converting their currencies at the prevailing exchange rate.
Basic Formula of Relative PPP
The relative form of PPP is calculated using the following equation:
S = P1 / P2
Where:
- S = Exchange rate between currency 1 and currency 2
- P1 = Price of a good in currency 1
- P2 = Price of the same good in currency 2
This formula provides a standardized approach to currency comparison based on the cost of goods.
PPP Versus CPI
- Conceptual Differences: While both PPP and the Consumer Price Index (CPI) relate to the cost of goods and services, they are distinct in purpose and methodology.
- PPP for Global Comparisons: PPP provides a comparative measure of currency value across countries, emphasizing long-term equilibrium and international living standards.
- CPI for Domestic Policy: The CPI tracks inflation within a single country by monitoring price changes in a fixed basket of goods. It is a national-level measure, useful for internal economic policy and inflation control.
Nominal GDP Versus PPP
Nominal GDP is the total value of all goods and services produced in a country, calculated using current market prices and converted into US dollars.
Challenges with Nominal GDP:
- Exchange Rate Volatility: Shifts in currency values can alter rankings even without actual changes in output.
- Data Revisions: India’s GDP data frequently undergoes revision, complicating timely comparisons.
- No Cost-of-Living Context: Nominal GDP fails to reflect purchasing capacity or living standards.
Why PPP Offers More Accuracy: GDP based on PPP adjusts for price-level differences, offering a more meaningful measure of what people can afford and how economies compare in real terms.
Why Governments Prefer Nominal Rankings
- Ease of Communication: Nominal GDP figures are easier to explain and are readily understood by the public.
- Showcasing Progress: They reflect recent economic developments, allowing governments to highlight achievements.
- Political Utility: Nominal growth figures help political actors gain credit for perceived economic improvements.
Neglect of PPP Rankings: Since India has consistently ranked third in PPP since 2009, and there has been no recent change, these rankings receive little attention in political discourse despite their economic accuracy.
Cost of Living Versus Nominal Income
Impact of Geographic Differences: Two individuals earning similar salaries may experience vastly different living standards depending on where they reside. For instance, life in Mumbai is far more expensive than in Patna.
The Big Mac Index: Developed in the 1980s, this index uses the price of a McDonald’s Big Mac as a reference to evaluate affordability and purchasing power in different countries.
Illustrative Comparison: Earning ₹23 lakh annually in India may seem average, but in PPP terms, a person in the United States would require ₹79 lakh to maintain the same standard of living. This highlights the practical relevance of PPP in global income comparison.
Strengths And Weaknesses Of PPP
Advantages of Using PPP
- More Reliable Over Time: PPP offers a stable measure of economic size and standard of living over the long term.
- Reflects Real Income: It adjusts for price differences, offering a more accurate picture of actual purchasing ability.
- Unaffected by Market Speculation: Unlike exchange rates, PPP remains steady, reflecting fundamental economic conditions.
Limitations of PPP
- Trade Barriers Distort Results: Tariffs, transportation costs, and quality differences can interfere with accurate price comparisons.
- Difficulty in Standardizing Consumption: Diverse consumption habits make it hard to define a universal basket of goods.
- Inapplicability for Short-Term Analysis: PPP does not account for real-time exchange rate movements, making it unsuitable for short-term financial decisions.