Real growth, Inflation, Nominal GDP and PPP GDP

A few days back I chanced upon a well made infographic from McKinsey comparing GDP of major Indian cities to GDP of midsized countries. According to McKinsey in 20 years, GDP of 5 major Indian cities will become touch the current GDP of some countries like Philippines, Malaysia and others.  Although I didn’t read the article that accompanied the inforgraphic, I wondered if the GDP growth rate assumed for this projection was real or nominal. Most economists when talking about GDP growth mean real growth rates since inflation doesn’t increase the living standards. This sometimes leads to a conflict when one compares actual increase in GDP with the GDP growth rate projected.

For example, India’s real GDP growth forecast is around 7.5% but the GDP will grow at a rate faster than this because of inflation. Assuming an inflation of 5% in near future, India’s GDP growth will be around 12.5% when measured in INR. As per IMF, India’s GDP in 2016 is projected at $2.09 Trillion when measured in 2016 $. Assuming a 7.5% real growth, India’s GDP in 10 years should be $4.3 Trillion measured in 2016 $. This is the estimate one sees in most blogs, publications, and databases and in all probability McKinsey also used this estimate in the article I mentioned above. The actual GDP increase will be different because of inflation.

Table 1: India’s GDP in $ in 2016 and 2026 not accounting for currency depreciation

Source: www.imf.org , own research

Since GDP of India is measured in INR and then converted to USD, the projections in Table 1 assume that USD to INR exchange rate will remain constant over 10 years. This is unlikely and future exchange rates will depend upon a lot of factors including inflation. Some of the widely used methods to forecast exchange rates are Purchasing Power Parity (PPP) approach, Relative Economic Strength Approach and various econometric and time series models. I will use PPP Method in this post because it is the simplest and most intuitive. PPP approach is based on “Law of One Price” which states that identical goods in different countries should have same price. PPP approach forecasts that exchange rates will change to offset the price change due to inflation. Let us consider the example of India and USA. Let us assume inflation rate in India at 5.0% and USA at 2.5% (I have used www.tradingeconomics.com estimates for USA’s 10 year expected inflation rate).This leads to an inflation differential of 2.5% (5.0%-2.5%) between the 2 countries. According to the PPP approach, exchange rate of USA will appreciate by roughly 2.5% to keep relative prices in 2 countries same. The exact appreciation will be slightly less but 2.5% is good enough for our purpose. A country’s GDP and growth rate is measured in its home currency and for India that is INR. So what will happen to the future GDP measured in USD when INR depreciates against it? Even though India’s nominal GDP growth is 12.5% annually when measured in INR, INR will depreciate against USD at 2.5% every year.  Hence, India’s GDP in 2026 in $ terms will be less than 12.5% because of INR’s expected depreciation against USD. This is the reason most economists use real growth rate while forecasting GDP because real growth is unaffected by exchange rates. Projecting GDP in nominal terms in a foreign currency (USD in India’s case) is full of pitfalls because we don’t know how exchange rates will behave in future. In our case, India’s projected nominal GDP growth rate should be 10.0% (12.5% - 2.5%) when measured in USD. This gives us a GDP of $5.42 Trillion in 2026 $.

Table 2: India’s GDP in $ in 2016 and 2026 accounting for currency depreciation (INR vs. USD)

Source: www.imf.org , own research

Now let’s focus on the other interesting debate, which is PPP GDP vs. Nominal GDP. GDP adjusted for prices is called Purchasing Power Parity or PPP GDP. For example, if the average cost of a basket of goods in USA is $1 while the average cost of same basket of goods in India is $0.25, each $ is worth 4 times in India than in USA. So if nominal Indian GDP is $2 Trillion, PPP Indian GDP will be $8 Trillion ($2 Trillion*$1/$0.25). The actual figures as per IMF are $2.09 Trillion and $7.97 Trillion and hence the real conversion ratio is slightly less than 4 (3.81).

In calculating PPP GDP, USA is considered the benchmark country and GDP of any other country is calculated by comparing relative prices of a basket of goods in that country and USA. PPP method has its fair share critics and the argument is that it is impossible to arrive at a same basket of goods for 2 countries that is optimum and represent the cost of living in 2 countries. One popular indicator to calculate PPP is The Big Mac Index, first proposed by The Economist newspaper. The Big Mac Index calculates the price of a McDonald’s Big Mac Burger across countries to arrive at the relative price levels in the countries. The argument is that Big Mac Burger is a homogeneous product across borders and its price in each country represents all factors of production such a raw materials, labour costs, electricity and rent in that particular country. Economists have argued endlessly about the appropriateness of The Big Mac Index but it remains the most widely used indicator to compare price levels across countries.

Now we are coming to the most exciting part of this post. How does growth rate and inflation affect PPP GDP? Let’s again compare India to USA. The table below shows the Nominal GDP and PPP GDP of both USA and India in 2016 and forecasts over next 10 years.

Table 3: Nominal and PPP GDP of India and USA in $ in 2016 and 2026 accounting for currency depreciation (INR vs. USD)

Source: www.imf.org , www.tradingeconomics.com , own research

For USA both Nominal and PPP GDP are same because USD is the benchmark currency for calculating PPP GDP. What about India’s PPP GDP in 2026? Let us try to calculate PPP GDP in 2026 in 2026 $ and not in 2016 $. This approach makes more sense because we should be comparing the expected prices between USA and India in 2026 for PPP calculations and not 2026 prices in 2016 $. The PPP GDP of USA in 2026 will be same as nominal GDP of USA in 2026 when calculated in 2026 $. That is the number I have put in the above table. The question is how can we calculate India’s PPP GDP in 2026 in USD and whether it will grow at nominal growth rate (10.0%) or the real growth rate (7.5%) or at some totally different rate?

Let us analyse the price growth in two countries over the next 10 years. Prices in India are projected to increase at 5.0% every year while the corresponding figure for USA is 2.5%. But INR is also expected to depreciate at 2.5% every year against USD. So in $ terms, effective price increase in India will be 2.5% annually. This is same as the annual price increase in USA. So both economies will have the same level of relative prices in 2026 as in 2016 because of equal price increase. Hence, the PPP conversion ratio should not change between 2016 and 2026. Considering our initial example, average cost of the same basket of goods in USA in 2026 should be $1.28 while the average cost of same basket of goods in India in 2026 will be $0.32 (2.5% annual increase for 10 years in both countries). Hence, every $ in India will remain 4 times as valuable when compared to USA. So what will be the PPP GDP of India in 2026? It should be 4 times the nominal GDP in 2026 when measured in 2026$. The real ratio in 2016 as per IMF is 3.81 and I have used the above example to illustrate the logic behind PPP theory and why relative prices should remain constant over the years. The PPP GDP forecast for India in 2026 as per my analysis comes out to be $20.66 Trillion; the number I have put in the Table 3.

Notes: An important point before I end this post. Law of One Price is an economic theory and ideally should hold, at least over short terms. In reality, the relative prices between 2 countries are a result of various other factors such as education, workforce efficiency and technology to name three. The relative price levels between 2 countries show huge short term variations when measured in $ because exchange rates also change due to speculation and market sentiments. It is highly likely that Law of One Price won’t hold in 10 years between USA and India and then both Nominal and PPP GDP of India will be different from what I have projected.