From a recent Casey Report:
I’d like to do a quick review of a subject you might remember from your college economics courses: nominal GDP vs. purchasing power parity GDP, often abbreviated “(PPP) GDP.” You’ll need to understand the difference between the two to fully appreciate Jayant’s article. If you’re already familiar with them, feel free to skip the rest the introduction.
For our purposes, the key difference between the two is that nominal GDP measures the amount of international goods a typical person can afford, while (PPP) GDP measures the amount of local goods a typical person can afford.
An example will help explain. Let’s say that a typical American makes $100/day, and a typical Thai citizen makes $40/day. To purchase an international good like an iPhone, both the American and the Thailander must pay $400. Therefore, in terms of iPhones, the American is better off, since he must work 4 days to pay for the iPhone, whereas the Thai citizen must work 10.
Local goods, on the other hand, tend to be much cheaper in developing countries. A nice meal in Thailand might cost $5, while the equivalent in the US would cost $20. Therefore, when measured in local goods, the Thai citizen is better off: he can buy eight nice meals with his salary, whereas his American counterpart can only afford five.
In economic jargon, we would say that the US’s nominal GDP per capita is higher than Thailand’s, because an American can afford more international goods than a Thailander can. By that same logic, Thailand is richer on a PPP basis, because a typical Thailander can afford more local goods than a typical American can (not really; just in our example).
Why the difference? Local goods use local inputs. The price of a hamburger in Thailand is a function of labor costs in Thailand, which are much cheaper than labor costs in the US. The Thai farmer who raised the cattle, the Thai chef who cooked the burger, and the Thai waiter who served it all make less money than their counterparts in America. Those cheaper inputs manifest in a cheaper product.
Taking it one step further, globalization causes a given country’s nominal and (PPP) GDP to converge. Imagine an identical truck produced in both Thailand and the US, only the truck cost $2,000 less in Thailand. Theoretically, an American could travel to Thailand, buy a truck, ship it home, and save $2,000.
Of course, only a mathematically challenged American would attempt such a stunt, since the costs of travel and shipping alone would more than eliminate the savings on the price of the truck.
But for a truck dealer who orders thousands of trucks at a time? It may very well be cost effective for him to ship ’em in from Thailand.
Based on that idea, differences between a country’s nominal and (PPP) GDPs should erode over time, as markets continue to globalize. Floating currencies allow this to happen smoothly: because it makes sense for companies in richer countries to buy trucks from Thailand, the Thai baht will appreciate, and Thailand’s nominal GDP will increase.
Taken to its extreme, in a perfectly globalized world with zero transaction costs, any given country’s nominal GDP would equal its (PPP) GDP… which means that any country with a much higher PPP than nominal GDP represents an investment opportunity. All else equal, its currency should appreciate over time…