Friday, January 16, 2015


China has officially passed the United States when it comes to the amount of goods and services that passes through its economy in a year, sort of ...

When it comes to measuring what the Chinese can purchase with their own currency - what economists call Purchasing Power Parity - the Chinese are now #1 in the world. What this means is that as a nation the Chinese can purchase more stuff in the aggregate than the United States.

So, what's Purchasing Power Parity (PPP), you ask? Good question.

In a few words, using PPP differs from the traditional way we measure economic activity because PPP focuses on how much a nation can purchase domestically in their own currency. The traditional way of measuring economic activity is to use U.S. dollars to gauge how much an economy produces each year.

So why use PPP, you ask? Another good question.

Measuring how much can be produced in U.S. dollars can be misleading. This is especially the case since the dollar has enjoyed a privileged position among the world's currencies since World War II. While there are issues tied to the growing amount of dollars in circulation around the world - which reduces its value over the long run - the U.S. dollar is still the world's reserve currency. Simply put, other nations accept and still want dollars, even if the dollar has become devalued over time because of the $1.3 trillion (and counting) that's in circulation around the world.

Apart from the privileged position of the dollar we also have challenges associated with speculation on currencies, interest rate shifts, etc. These fluctuations help to make some currencies stronger or weaker.1

All of this helps explain why vacationing U.S. citizens can use the dollar to purchase more goods in some countries when they travel. There are many factors that help raise, or reduce, the value of the dollar (or any currency, for that matter). If done correctly, using PPP can help reduce currency fluctuations by muzzling the privileged position of the dollar - while filtering out other inflating or deflating factors2 - from the currency exchange equation.3

So, in the case of China above, if we remove the privileged position of the dollar (among others), and focus on how much their national currency can purchase domestically, we end up with China being able to purchase more goods and services than the United States.

However, this doesn't necessarily mean the Chinese are richer. Not by a long shot.

What the Chinese currency can purchase internally ($17.5 trillion) must be spread out between 1.36 billion people (about $12,800 per person). The fact that China's wealth is concentrated in the hands of the few makes it clear that China's place atop the PPP perch may not mean as much as some might want to suggest.

Conversely, the purchasing power of the U.S. ($14.6 trillion) is divided by 316.1 million people (about $46,000 for every person). While wealth gaps in the U.S. are bad and getting worse, there's no doubt that individual Americans enjoy better purchasing prospects that the average Chinese citizen.

Of course, if we measure how many goods and services an economy can produce using the traditional dollar denominated method (simple GDP) the U.S. remains the world's top producer, having produced $17.5 trillion worth of "stuff" in 2014.

For their part the Chinese produced a little over $10 trillion in goods and services.

Click here for a list of countries whose currencies are under or over valued according to the PPP method.

- Mark

     1. For many PPP may be confusing, and helps explain why no one really likes talking to economists about the world. I understand. If you find yourself confused, you might want to take a look at this example (which, I suspect, many will find even more confusing).

     2. We want to keep in mind that, apart from muzzling the privileged position of the dollar, the PPP formula also filters out several other currency manipulating factors. Specifically, it helps reduce the manipulative impact of inflation expectations, short term fluctuations, interest rate changes, and growth expectations from currency exchange rates.

     3. The end result is that PPP is supposed to help us determine where the exchange rate "should" be. The thinking (or the theory) behind the PPP method is that exchange rates should be at a level where a basket of goods can be purchased for the same price in either country.

No comments: