1001.0 - Annual Report - ABS Annual Report, 2001-02
Previous ISSUE Released at 11:30 AM (CANBERRA TIME) 16/10/2002
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Contents >> Section 2 - Special Articles >> Chapter 4 - The International Comparison Program - Calculating PPP statistics

The calculation of high quality PPP statistics requires high quality national accounts and price data for each of the countries for which PPPs are being calculated. Price data are weighted using national accounts data to form PPPs which are then normally divided into national accounts aggregates to convert them to a common currency.

PPPs are calculated in two stages. First, at the most detailed level for which weighting data are available (the ‘basic heading’ e.g. Bread), PPPs are derived based on the price ratios for all the items representative of each country’s expenditure and which can be matched between each pair of countries in the comparison. The second stage is to combine the basic heading PPPs using national accounts data as the weights to provide PPPs for each level of aggregation (e.g. household final consumption expenditure) up to GDP. There are several formulas available for use in this stage of the process. As is common with index number formulas, there is no ‘perfect’ choice of formula. It has been demonstrated that the formula used in the OECD-Eurostat PPP Program since 1990 produces unbiased results, although the downside is that additivity between the national accounts components and higher level aggregates such as GDP is lost in the aggregation process. The aggregation formula used prior to the 1990 round (and used in all rounds of the ICP to date) produced additive results but they could be biased in certain circumstances. The bias was particularly severe when a comparison was being made between countries at significantly different stages of economic development, with the per capita volume of activity being overstated for the less developed countries when they were being compared with the more economically advanced ones.

On the other hand, exchange rate comparisons are significantly biased and systematically understate per capita GDP in less economically developed countries compared with those with relatively high GDP per capita. The reason is based on the productivity differentials between high and low income countries and is described as follows by the architects of the ICP:

"International trade tends to drive the prices of traded goods, mainly commodities, towards equality in different countries (based on exchange rates). With equal or nearly equal prices, wages in the traded goods industries in each country will depend upon productivity. Wages established in the traded goods industries within each country will prevail in the country's nontraded goods industries. In nontraded goods industries, however, international productivity differentials tend to be smaller. Consequently, in a high productivity country high wages lead to high prices of services and other nontraded goods, whereas in a low productivity country low wages produce low prices. The lower a country's income, the lower will be the prices of its home goods and the greater will be the tendency for exchange rate conversions to underestimate its real income relative to that of richer countries."(See footnote 2)

2 Page 9 of International comparisons of real product and purchasing power (Irving B Kravis, Alan Heston, and Robert Summers) - John Hopkins University Press, Baltimore, 1978.

How the biases associated with comparisons of volumes of activity based on exchange rates translate into assessments of changes in inequality is difficult to establish with any precision. It is clear, however, that exchange rates do not provide a suitable starting point for assessing changes over time because they are such a fundamentally flawed means of comparison. Based on exchange rates, the gap in per capita income between the countries with the richest fifth of the world’s population and those with the poorest fifth increased from a factor of 30 to 1 in 1960 to 74 to 1 in 1995. Ian Castles (a former Australian Statistician) pointed out in a report(see footnote 3) criticising the inappropriate use of exchange rates in making international comparisons that, based on PPPs, this ratio was about 12 to 1 in 1960, 18 to 1 in 1990 and 16 to 1 in 1995. The differences observed above in the two sets of time series indicate that per capita volumes based on exchange rates are not able to be used as an indicator of changes over time either, because they are so (implausibly) different from the PPP-based measures. In other words, not only do exchange rate based comparisons produce extreme and meaningless estimates of relative levels but they also produce meaningless results over time. In addition, the table on page 52 which shows the comparison between the USA and Japan based on exchange rates and on PPPs, demonstrates empirically that time series of comparisons based on exchange rates produce results which are economically implausible, even when they are between two high-income countries. In practice, the only certainty with exchange rate based comparisons is that, for any point in time, they will significantly overstate the difference in per capita GDP volumes between high and low income countries. It is impossible to provide a definitive answer to the question of the extent of the change in this bias over time because it will depend on the countries being compared, the extent of the differences in the structure of their economies at each point in the time series under consideration and other factors which affect exchange rates (e.g. financial flows or interest rates).

3 The mismeasurement of nations: A review essay on the Human Development Report 1998 (Ian Castles) - Paper published in the Population and Development Review 24(4), December 1998.

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