By the end of this section, you will be able to:
- Explain how we can use GDP to compare the economic welfare of different nations
- Calculate the conversion of GDP to a common currency by using exchange rates
- Calculate GDP per capita using population data
It is common to use GDP as a measure of economic welfare or standard of living in a nation. When comparing the GDP of different nations for this purpose, two issues immediately arise. First, we measure a country's GDP in its own currency: the United States uses the U.S. dollar; Canada, the Canadian dollar; most countries of Western Europe, the euro; Japan, the yen; Mexico, the peso; and so on. Thus, comparing GDP between two countries requires converting to a common currency. A second issue is that countries have very different numbers of people. For instance, the United States has a much larger economy than Mexico or Canada, but it also has almost three times as many people as Mexico and nine times as many people as Canada. Thus, if we are trying to compare standards of living across countries, we need to divide GDP by population.
Converting Currencies with Exchange Rates
To compare the GDP of countries with different currencies, it is necessary to convert to a “common denominator” using an exchange rate, which is the value of one currency in terms of another currency. We express exchange rates either as the units of country A’s currency that need to be traded for a single unit of country B’s currency (for example, Japanese yen per British pound), or as the inverse (for example, British pounds per Japanese yen). We can use two types of exchange rates for this purpose, market exchange rates and purchasing power parity (PPP) equivalent exchange rates. Market exchange rates vary on a day-to-day basis depending on supply and demand in foreign exchange markets. PPP-equivalent exchange rates provide a longer run measure of the exchange rate. For this reason, economists typically use PPP-equivalent exchange rates for GDP cross country comparisons. We will discuss exchange rates in more detail in Exchange Rates and International Capital Flows. The following Work It Out feature explains how to convert GDP to a common currency.
Work It Out
Converting GDP to a Common Currency
Using the exchange rate to convert GDP from one currency to another is straightforward. Say that the task is to compare Brazil’s GDP in 2020 of 7.4 trillion reals with the U.S. GDP of $20.9 trillion for the same year.
Step 1. Determine the exchange rate for the specified year. In 2020, the exchange rate was 2.362 reals = $1. (These numbers are realistic, but rounded off to simplify the calculations.)
Step 2. Convert Brazil’s GDP into U.S. dollars:
Step 3. Compare this value to the GDP in the United States in the same year. The U.S. GDP was $20.9 trillion in 2020, which is almost seven times that of GDP in Brazil.
Step 4. View Table 6.8 which shows the size of and variety of GDPs of different countries in 2020, all expressed in U.S. dollars. We calculate each using the process that we explained above.
|Country||GDP in Billions of Domestic Currency||Domestic Currency/U.S. Dollars (PPP Equivalent)||GDP (in billions of U.S. dollars)|
GDP Per Capita
The U.S. economy has the largest GDP in the world, by a considerable amount. The United States is also a populous country; in fact, it is the third largest country by population in the world, although well behind China and India. Is the U.S. economy larger than other countries just because the United States has more people than most other countries, or because the U.S. economy is actually larger on a per-person basis? We can answer this question by calculating a country’s GDP per capita; that is, the GDP divided by the population.
The second column of Table 6.9 lists the GDP of the same selection of countries that appeared in the previous Tracking Real GDP over Time and Table 6.8, showing their GDP as converted into U.S. dollars (which is the same as the last column of the previous table). The third column gives the population for each country. The fourth column lists the GDP per capita. We obtain GDP per capita in two steps: First, by multiplying column two (GDP, in billions of dollars) by 1000 so it has the same units as column three (Population, in millions). Then divide the result (GDP in millions of dollars) by column three (Population, in millions).
|Country||GDP (in billions of U.S. dollars)||Population (in millions)||Per Capita GDP (in U.S. dollars)|
Notice that the rankings by GDP in billions of U.S. dollars, and by GDP per capita, are different than the ranking of GDP by each country’s currency. Measured by its own currency, the rupee, India has a somewhat larger GDP than Germany. On a per capita basis in U.S. dollars, Germany has more than 9 times India’s per capita GDP on PPP terms.
Clear It Up
Is China going to surpass the United States in terms of standard of living?
China has the largest GDP in PPP terms: $24 trillion compared to the United States’ $21 trillion. But China has a much larger population so that in per capita terms, its GDP is less than one fourth that of the United States ($17,000 compared to $63,000). The Chinese people are still quite poor relative to the United States and other developed countries. One caveat: For reasons we will discuss shortly, GDP per capita can give us only a rough idea of the differences in living standards across countries.
The world’s high-income nations—including the United States, Canada, the Western European countries, and Japan—typically have GDP per capita in the range of $20,000 to $50,000. Middle-income countries, which include much of Latin America, Eastern Europe, and some countries in East Asia, have GDP per capita in the range of $6,000 to $12,000. The world's low-income countries, many of them located in Africa and Asia, often have GDP per capita of less than $2,000 per year.