The U.S. economy has been the world’s largest since overtaking the U.K. economy in 1872, but its reign may just be over. According to one method of making inter-country GDP comparisons, China is now the world’s biggest producer. (See related: The 3 Industries Driving China's Economy.) Yet, according to another method, the U.S. economy is still significantly larger than China’s. The best method, and hence which economy is larger, all depends on one’s methodology and motivations for making the comparison in the first place.
Inter-Country Comparison Problems
The GDP measures the monetary value of all final goods and services produced in a country over a given period of time. The key word here is monetary, since value itself is unobservable. All one can observe are the prices (i.e. monetized values) at which goods and services exchange. So far so good.
Problems soon become evident when trying to compare U.S. goods and services priced in dollars with Chinese goods and services priced in yuan, which are two different units to measure value. Unless one knows the conversion factor, comparisons between two separate currency units are meaningless. Fortunately, we do have a conversion factor; somewhat unfortunately, we actually have two conversion factors that can have large discrepancies.
The two conversion factors at our disposal are market exchange rates and purchasing power parity (PPP) rates. According to the World Bank, at market exchange rates, China’s GDP for 2014 was $10.36 trillion, compared to the U.S. figure of $17.42 trillion. However, the World Bank’s figures at PPP rates reveal that China’s GDP for 2014 was $18.03 trillion, while the U.S. figure is still the same $17.42 trillion. That’s a significant difference.
Market Exchange Rates vs. Purchasing Power Parity
The market exchange rate measure uses the prevailing rate in the foreign exchange market either at the end of the period in question, or averaged over that period. The PPP exchange rate measure, contrastingly, uses the rate at which one currency would need to be converted to another currency in order to buy an equivalent amount of goods and services in each country.
While the market exchange rate measure seems simple enough, let’s look at an example to better illustrate the PPP measure. Suppose that it costs an average of $5 to buy a hamburger in the U.S., while it costs an average of 17 yuan to buy one in China. That means the PPP exchange rate of dollars to yuan should be 17/5 = 3.4, since that would be the rate that would effectively make hamburgers the same price in each country.
However, basing inter-country GDP comparisons on the relative prices of a single good in separate countries is inadequate. It is important to consider a broad range of goods and services, which is exactly what the International Comparisons Program (ICP) attempts to do. The ICP has developed a Global Core List of over 1,000 goods and services comparable across different regions and priced by all participating countries.
Advantages and Disadvantages
One of the reasons that PPP became an important method was that where the market exchange rate method converts GDP to a common currency, it fails to take into account the relative purchasing power of each currency in its respective country. While the market exchange rate method accounts for the purchasing power of internationally traded goods and services, it fails to reflect the fact that many goods and services are relatively cheaper in some countries than others; this is particularly true of developing countries like China.
Another advantage of PPP rates is that they tend to be more stable over time, whereas market exchange rates are much more volatile. Aggregate measures of growth will fluctuate with the same volatility as exchange rates even when actual growth rates are relatively stable.
The disadvantages of the market exchange rate method have been noted already by highlighting the relative advantages of the PPP method. However, one advantage of market exchange rates over PPP rates is the relative ease with which one can do the calculations. Because there is so much more involved in the PPP calculations (i.e. choosing the appropriate basket of goods and services and assigning appropriate weights to each), it is much easier for inaccuracies to be introduced.
The Bottom Line
In trying to determine which GDP measurement method is best for comparing the relative size of different economies, it is important to understand why you are making the comparison in the first place. If your goal is to use GDP as a measure to compare living standards, then using the PPP method may be your best option as it more adequately measures the relative purchasing power of each currency within its respective country. However, if your concerns are geopolitical, then the exchange rate method is best as it is better at measuring the relative importance of a country’s trading partners. The question of whether the Chinese economy is bigger than the U.S. economy may make nice headlines, but it matters little if one is unsure of why GDP measurements matter to begin with.
