Gross Domestic Product (GDP): Nominal vs PPP

Wikipedia entry for Gross Domestic Product (http://en.wikipedia.org/wiki/Gross_domestic_product) says: Gross domestic product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period of time.

GDP is a measure of how productive and hence how prosperous the people of a country are. Also, there are two ways GDP of a country is described - in Nominal and Purchasing Power Parity terms.

What does the GDP and the other terms really mean? 


In this post, we will understand them using the language of layconomics where we prefer to describe things without using the concept of money. Please read Real growth, prosperity and the standard of living and Why Layconomics? for some background.


To use the language of layconomics, we have to create two villages, A and B, as usual. Let's say, there are three people in each village. In village A, the first person produces three bags of grain every year, the second person builds three huts (that last a year each) and the third person sows outfits from dead animals' leather for clothing. However, it so happens that the clothing produced is enough to cover nine people instead of just three. The three people use barter to exchange goods and services. The exchange is as follows:

1. The first person exchanges one bag of grain for one hut with the second person
2. The first person exchanges one bag of grain for one outfit from the third person
3. Finally, the second person exchanges one hut for one outfit with the third person 

Hence, the third person has a saving of six outfits every year that can build up year over year (he is the rich designer of the village!). The village subsists itself via mutual exchange of goods.

Now, we can say that the Gross Domestic Product of village A is fifteen bags of grain. Why? Because:

1. The first person produces three bags of grain every year
2. The second person produces three huts every year where each is worth one bag of grain (as determined by the market value that one hut commanded)
3. The third person produces nine outfits every year where each is worth one bag of grain (as determined by the market value that one outfit commanded)

Next, let's visit village B. Let's imagine that village B is exactly the same as village A producing its own version of grain, huts and outfits. Therefore, similar to village A, village B also has a Gross Domestic Product of fifteen bags of grain. Therefore, we can say that GDP of both villages is fifteen bags of grain.

Let's also imagine that village A and B establish trade relations and exchange their excess outfits with each other. However, the exchange turns out to be favorable for village B, because village B's outfits are more desirable. Village A has to cough up two outfits for one outfit of village B.

Now, to GDP (Nominal) and GDP (PPP). To compare the GDP of both villages, we want to describe the GDP of both villages using a common denomination, maybe in terms of bags of grain from village A. We can do it in two ways. In the first method of comparison (Nominal GDP), we do this by taking the exchange ratio determined by trade into account. We can, immediately, see that the GDP of village B is twice that of village A. Why? Because every bag of grain of village B is worth two bags of village A grain. To see this, we note that the trade established between the two villages determined that every village B outfit was worth two village A outfits. And since the internal exchange ratio of village A determined that one village A outfit is worth one bag of village A grain and the same with village B, we can conclude that one bag of grain from village B is worth two bags of grain from village A. Therefore, we are forced to conclude that the GDP (nominal) in terms of bags of village A grain is fifteen bags for village A and thirty bags for village B.

Now, to the second method of comparing a bag of grain from village A to a bag of grain from village B. This method is used for describing the GDP of both villages in purchasing power parity (PPP) terms. In this method, we want the true value (not the one obtained from the exchange ratio determined by trade) of a bag of grain of village B in terms of a bag of village A grain. This is called the basic basket of goods required for sustenance. Going by the eating habits of both villages and the nutritional value of each grain, one bag of village A is determined to be worth exactly one bag of village B. Therefore, in terms of purchasing power parity the GDP of both villages is fifteen bags of grain of village A.

In summary, in this post, we saw that the relative prosperity of two countries can be artificially distorted by trade relations between the two countries and is solely determined by the goods actually traded. Also, we got a glimpse that a country's prosperity is better described by GDP (PPP) than by GDP (nominal). Here is a nice picture from Wikipedia to go along with this conclusion (http://en.wikipedia.org/wiki/File:Gdp_nominal_and_ppp_2005_world_map_single_colour.png).