Thanks to factors such as shipping freights, mass production scales and, a massive interconnected network of suppliers; economies on a global scale have changed, with some surpassing others. Overtaking the U.K in 1872, the U.S economy has been the world’s largest economy by a significant scale; however the tables seem to be turning once again.
Based on countries GDP, China is arguably the world’s largest producer in terms of manufacturing, agriculture and services; however according to another method, the U.S. economy is still significantly larger than China’s. In order to clear the fog one should note the following to make a more accurate statement on who holds the world title.
Firstly, 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 at which goods and services exchange.
With this problems soon become evident when trying to compare U.S. goods and services priced in dollars with Chinese goods and services priced in yuan, unless one knows the conversion factor on a constant basis; an monotones task if ever there was one. Fortunately, we do have a conversion factor; somewhat unfortunately however, 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). 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; just enough to make a difference.
Another factor to consider is the market exchange rate vs purchasing power. 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 us take for example a humble sandwich that costs $2 in the U.S while it costs ¥10 in China. This means that the exchange rate of dollars to Yuan should be 10/2 = 5, as that would be the rate that would effectively make sandwiches the same price in each country; However, basing a country’s 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 one thousand goods and services comparable across different regions and priced by all participating countries.
At the end of the day, and so as to answer the headlining question of which economy is larger, the simple and somewhat disappointing answer would be, it depends.
If your goal is to use GDP as a measure to compare living standards, then using the PPP method may be your best shot as it more than 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.
This article was issued by Steve Diacono for Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.