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Finance and capital markets
Course: Finance and capital markets > Unit 8
Lesson 5: Foreign exchange and trade- Currency exchange introduction
- Currency effect on trade
- Currency effect on trade review
- Pegging the yuan
- Chinese Central Bank buying treasuries
- American-Chinese debt loop
- Debt loops rationale and effects
- China keeps peg but diversifies holdings
- Carry trade basics
- Comparing GDP among countries
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Comparing GDP among countries
Key Points
- Since GDP is measured in a country’s currency, in order to compare different countries’ GDPs, we need to convert them to a common currency.
- One way to compare different countries' GDPs is with an exchange rate, the price of one country’s currency in terms of another.
- GDP per capita is GDP divided by population.
Introduction
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, the GDP of a country is measured in its own currency—the United States uses the US dollar; most countries of Western Europe use the euro; Japan uses the yen; and Mexico uses the peso. Because of this, 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 roughly three times as many people as Mexico and nine times as many people as Canada. So, 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.
Exchange rates are expressed 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—British pounds per Japanese yen. Two types of exchange rates can be used to compare GDPs: market exchange rates and purchasing power parity, or 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, PPP-equivalent exchange rates are typically used for cross-country comparisons of GDP.
GDP per capita
The US 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 it's well behind China and India. So is the US economy larger than other countries' economies just because the United States has more people or because the US economy is actually larger on a per-person basis? This question can be answered by calculating countries' GDP per capita—the GDP divided by the population.
To calculate GDP per capita, we start with the formula below.
We can use the table below to fill in the formula. The second column lists the GDP of various countries converted into US dollars. The third column gives the population for each country. The fourth column lists the GDP per capita—no cheating, don't look at this column yet!
GDP per capita is obtained in two steps:
- Make sure your GDP and population numbers are in the same units. In our example, GDP is currently in billions, but population is in millions. We'll need to divide GDP by 1000 so it has the same units as population.
- Divide GDP by population.
Once you've done the calculations for each of the countries yourself, you can check your work against the fourth column of the table.
| Country | GDP in billions of US dollars | Population in millions | Per capita GDP in US dollars |
|---|---|---|---|
| Brazil | 2,246.00 | 199.20 | 11,172.50 |
| Canada | 1,826.80 | 35.10 | 52,037.10 |
| China | 9,469.10 | 1,360.80 | 6,958.70 |
| Egypt | 271.40 | 83.70 | 3,242.90 |
| Germany | 3,636.00 | 80.80 | 44,999.50 |
| India | 1,876.80 | 1,243.30 | 1,509.50 |
| Japan | 4,898.50 | 127.3 | 38,467.80 |
| Mexico | 1,260.90 | 118.40 | 10,649.90 |
| South Korea | 1,304.47 | 50.20 | 25,975.10 |
| United Kingdom | 2,523.20 | 64.10 | 39,371.70 |
| United States | 16,768.10 | 316.30 | 53,001.00 |
Notice that ranking by GDP is different from ranking by GDP per capita. For example, India has a somewhat larger GDP than South Korea, but on a per capita basis, South Korea has more than 10 times India’s standard of living.
Summary
- Since GDP is measured in a country’s currency, in order to compare different countries’ GDPs, we need to convert them to a common currency.
- One way to compare different countries' GDPs is with an exchange rate, the price of one country’s currency in terms of another.
- GDP per capita is GDP divided by population.
Self-check questions
Is it possible for GDP to rise while at the same time per capita GDP is falling? Is it possible for GDP to fall while per capita GDP is rising?
The Central African Republic has a GDP of 1,107,689 million CFA francs and a population of 4.862 million. The exchange rate is 284.681 CFA francs per dollar. Calculate the GDP per capita of Central African Republic.
Review question
What are the two main difficulties that arise in comparing the GDP of different countries?
Critical thinking questions
- Cross-country comparisons of GDP per capita typically use purchasing power parity, PPP, equivalent exchange rates, which are a measure of the long-run equilibrium value of an exchange rate. In fact, we used PPP equivalent exchange rates in this article. Why could using market exchange rates, which sometimes change dramatically in a short period of time, be misleading?
- Why might per capita GDP be only an imperfect measure of a country’s standard of living?
Problems
- Ethiopia has a GDP of 8 billion US dollars and a population of 55 million. Costa Rica has a GDP of 9 billion US dollars and a population of 4 million. Calculate the per capita GDP for each country and identify which one is higher.
- In 1980, Denmark had a GDP of 70 billion US dollars and a population of 5.1 million. In 2000, Denmark had a GDP of 160 billion US dollars and a population of 5.3 million. By what percentage did Denmark’s GDP per capita rise between 1980 and 2000?
- The Czech Republic has a GDP of 1,800 billion koruny. The exchange rate is 20 koruny per US dollar. The Czech population is 20 million. What is the GDP per capita of the Czech Republic expressed in US dollars?
Want to join the conversation?
The first point in this article states that "Since GDP is measured in a country’s currency, in order to compare different countries’ GDPs, we need to convert them to a common currency."
Why is the US$ used as the common currency?Why not British pounds or Indian Rupees?(1 vote)
The $ is the world's most heavily traded currency and the price of commodities such as gold which used to underpin wealth, is tied to it(3 votes)
Why does it say that one have to divide the GDP by 1000 in order to have the same units as population? I got a different answer if I divided the GDP by 1000 and then divide it by the population.(1 vote)
A country which we can call Country S, has a total population of 20,000 people. Out of the
population, 5,000 are non-indigenes while the remaining are indigenes. The country also has
2,000 citizens who are resident in different countries. The money value of the total output
produced are as follows:
Indigene living in the Country S 220,000
Non-indigenes living in Country S 100,000
Indigenes of Country S living abroad (net income) 30,000
You are required to calculate:
1. The GDP of Country S.
2. The GNP of Country S.
3. The per capita income of the country.
4. What is per capita income?(0 votes)