ICP 2021: Concepts and definitions

The ICP approach to GDP comparisons

Market exchange rates

Purchasing power parities

Price level indexes

PPP-based expenditures

GDP compared with gross national income

Actual individual consumption and Total consumption

The ICP approach to GDP comparisons

The International Comparison Program (ICP) comparisons of gross domestic product (GDP) are based on the value of an individual item equaling the product of its price and quantity (that is, the identity: value = price × quantity). Once more than one item is involved, the identity can no longer be expressed in terms of price × quantity. Therefore, in ICP terms, it becomes value = price × volume.

GDP is a measure of production within an economy, and it is commonly estimated as the sum of the value of the outputs from production less the cost of the goods and services used in their production—the so-called production approach. It also can be estimated as the sum of the final expenditures on goods and services plus exports less imports of goods and services, which is known as the expenditure side of national accounts and is the approach used by the ICP. Yet another alternative is to estimate GDP as the sum of the incomes arising from production (wages, profits, and so forth), which is referred to as the income approach. In theory, the three approaches yield the same result. However, whereas values estimated from the production approach and the expenditure approach can be split into meaningful price and volume components, values estimated from the income side cannot. In other words, price and volume comparisons of GDP can be made from the production approach and from the expenditure approach, but not from the income approach. ICP comparisons are made from the expenditure approach. This approach allows comparison of the levels of the principal elements of final demand—that is, consumption and investment. It also avoids the difficulties encountered in organizing comparisons from the production approach, which requires data for both intermediate consumption and gross output in order to effect double deflation. The disadvantage of the expenditure approach is that, unlike the production approach, it does not identify individual industries, and so productivity can be compared only at the level of the whole economy. On the other hand, a major advantage is that the estimates of final demand can be used in many different types of economic analysis, including forecasting and poverty analysis.

Economies estimate their expenditures on GDP at national price levels and in local currency units. But before these nominal expenditures can be used to compare the volumes of goods and services produced by economies, differences in national price levels must be eliminated and local currency units must be converted to a common currency. Differences in price levels between economies can be removed, either by observing volumes directly as the sum of their underlying quantities or by deriving them indirectly using a measure of relative prices, to place the expenditures of all economies on the same price level. Prices are easier to observe than quantities, and direct measures of relative prices usually have a smaller variability than direct measures of relative quantities. In ICP comparisons, volumes are mostly estimated indirectly using direct measures of relative prices—purchasing power parities (PPPs)—to deflate nominal expenditures. In addition to being spatial price deflators, PPPs are currency converters. Thus PPP-deflated expenditures are expressed in a common currency unit and valued at the same price level.

Market exchange rates

Before PPPs became widely available, market exchange rates were used to make international comparisons of GDP. Market exchange rates, however, only convert GDP to a common currency. They do not provide GDP valued at a common price level because market exchange rates do not reflect currencies' relative purchasing power in their national markets. For them to do so, all goods and services would have to be traded internationally, and the supply and demand for currencies would have to be driven predominantly, if not solely, by the currency requirements of international trade. But this is not the case. Many goods and services— such as buildings, government services, and most household market services—are not traded internationally, and the supply and demand for currencies are influenced primarily by factors such as currency fluctuations, interest rates, government intervention, and capital flows between economies. Consequently, as equation 1.2 in the box below indicates, GDP converted to a common currency using market exchange rates remains valued at national price levels. The differences between the levels of GDP in two or more economies reflect both differences in the volumes of goods and services produced by the economies and differences in the price levels of the economies. However, as equation 1.4 in the box shows, GDP converted with PPPs reflect only differences in the volumes produced by the economies.

Market exchange rate-converted GDP—that is, nominal GDP converted to a common currency using market exchange rates—can be highly misleading when used to compare the relative size of economies. Price levels are normally higher in high-income economies than they are in low-income economies; as a result, differences in price levels between high-income economies and low-income economies are greater for nontraded items than they are for traded items. Before the addition of tariffs, subsidies, and trade costs, the prices of traded items are basically determined globally by the law of one price, whereas the prices of nontraded items are determined by local circumstances, in particular, by wages and salaries, which are generally higher in high-income economies. If the larger differences in price level for nontraded items are not taken into account when converting GDP to a common currency, the size of high-income economies with high price levels will be overstated, and the size of low-income economies with low price levels will be understated. This is known as the Penn effect. No distinction is made between traded items and nontraded items when market exchange rates are used to convert GDP to a common currency—the rate is the same for all items. PPP-converted GDP does not have this bias because PPPs are calculated first for individual items and thus take into account the different price levels for traded items and nontraded items.

ICP PPPs are designed specifically for international comparisons of GDP. They are not designed for comparisons of monetary flows or trade flows. International comparisons of flows—such as development aid, foreign direct investment, migrants’ remittances, or imports and exports of goods and services—should be made with market exchange rates, not with PPPs. 

Purchasing power parities

PPPs are price relatives that show the ratio of the prices in local currency units of the same good or service in different economies. For example, if the price of an apple is €0.60 in France and $0.50 in the United States, the PPP for apples between the two economies is $0.83 to the €1.00 from France’s perspective (0.50/0.60) and €1.20 to the dollar from the United States’ perspective (0.60/0.50). In other words, for every €1.00 spent on apples in France, $0.83 would have to be spent in the United States to obtain the same quantity and quality—that is, the same volume—of apples. Conversely, for every $1.00 spent on apples in the United States, €1.20 would have to be spent in France to obtain the same volume of apples. To compare the volumes of apples purchased in the two economies, either the expenditure on apples in France can be expressed in dollars by dividing by 1.20, or the expenditure on apples in the United States can be expressed in euros by dividing by 0.83.

PPPs are calculated in stages: first for item groups, then for various aggregates, and finally for GDP. PPPs continue to be price relatives whether they refer to an item group, to an aggregate, or to GDP. As one moves up the aggregation hierarchy, the price relatives refer to increasingly complex assortments of goods and services. Therefore, if the PPP for GDP between France and the United States is €0.69 to $1.00, it can be inferred that for every $1.00 spent on GDP in the United States, €0.69 would have to be spent in France to purchase the same volume of goods and services. Purchasing the same volume of goods and services does not mean that the baskets of goods and services purchased in both economies will be identical. The composition of the baskets will vary between economies and reflect differences in taste, culture, climate, price structure, item availability, and income level, but both baskets will, in principle, provide equivalent satisfaction or utility.

Price level indexes

PPPs are spatial price indexes. They show, with reference to a base economy (or region), the price of a given basket of goods and services in each of the economies being compared. This index is similar to a temporal price index, which shows, with reference to a base period, the price of a given basket of goods and services at different points in time. However, unlike a temporal price index in which the indexes at the different points in time are expressed in the same currency unit so that changes in price over time are readily identifiable, the PPP index for each economy is expressed in the economy’s local currency. It is thus not possible to say whether one economy is more expensive or less expensive than another. For this type of comparison, one would have to standardize the indexes by expressing them in a common unit of currency. The common currency used for the ICP global comparison is the US dollar, so each economy’s PPP has been standardized by dividing it by that economy’s dollar market exchange rate. The standardized indexes so obtained are called price level indexes (PLIs).

Economies with PLIs greater than 100 have price levels that are higher than that of the base economy. Economies with PLIs less than 100 have price levels that are lower than that of the base economy. So, returning to the apple example, if the market exchange rate is $1.00 to €0.85, the PLI for an apple in France with the United States as the base economy is 141 (1.20/0.85 × 100). From this, it can be inferred that, given the relative purchasing power of the dollar and the euro, apples cost 41% more in France than they do in the United States. In addition to items, PLIs can be calculated for GDP and its expenditure components. At the level of GDP, PLIs provide a measure of the differences in the general price levels of economies. Thus, if the PPP for GDP between France and the United States is €0.69 to $1.00, the PLI for GDP for France based on the United States set equal to 100 is 81 (0.69/0.85 × 100), indicating that the general price level of France is 19 percent lower than that of the United States. The PLIs of economies can be compared directly. For example, if the PLI of one economy is 120 while that of another economy is 80 (both with the United States as base), then it is valid to infer that the price level is 50 percent (that is, 120/80) higher in the former than in the latter.

It is worth remembering that changes in PPPs evolve slowly, whereas market exchange rates can change rapidly. Sudden changes in PLIs are usually the result of fluctuations in market exchange rates. When market exchange rates change rapidly, a PLI for an economy could change rapidly as well, reflecting the fact that an economy that was relatively cheap has now become relatively expensive compared with the base economy. The volatility of market exchange rates is another reason they should not be used to compare the size of economies. Fluctuations in market exchange rates can make economies appear suddenly larger or smaller even though there has been little or no change in the relative volume of goods and services produced.

PPP-based expenditures

Economies report aggregate and detailed nominal expenditures on GDP in local currency units. Nominal expenditures are expenditures that are valued at national price levels. They can be expressed in local currency units or, when converted by market exchange rates, in a common currency. In the latter, the converted expenditures remain nominal because market exchange rates do not correct for differences in price levels between economies, and so the expenditures are still valued at national price levels. For the ICP, economies report their nominal expenditures in local currency units. PPPs are used to convert these nominal expenditures to PPP-based expenditures. PPP-based expenditures are expenditures that are valued at a common price level. They reflect actual differences in the volumes purchased in economies and provide the measures required for international comparisons of volume: indexes of PPP-based expenditure and indexes of PPP-based expenditure per capita.

GDP compared with gross national income

GDP measures the production by producers who reside within an economy’s territory. The income generated from such production is distributed mainly to residents of the economy, but some of the income may accrue to nonresidents (such as the interest or dividends that have to be paid abroad or the cost of servicing foreign debt). Similarly, some residents may receive income from nonresidents (such as interest or dividends paid to residents from abroad). For some types of analysis, these income flows can be of interest, which leads to the concept of gross national income (GNI). GNI measures the value of the incomes received by residents. It differs from GDP by the net amount of the income flows between an economy’s residents and the residents of other economies.

Actual individual consumption and Total consumption

One aggregate below the level of GDP that has particular significance in ICP comparisons is actual individual consumption (AIC), which measures the individual goods and services that households actually consume as opposed to what they actually purchase. AIC includes the value of what households purchase (that is, individual consumption expenditure of households) plus the value of services they receive from the government and nonprofit institutions serving households (NPISHs), such as charities and nongovernmental organizations. On a per capita basis, AIC is conceptually a better measure of average material well-being than individual consumption expenditure of households alone when material well-being is defined in terms of the goods and services consumed by households to satisfy their individual needs. This is because it covers all consumption expenditures directly benefiting households irrespective of the purchaser of the goods and services.

AIC is used because in some economies the government or NPISHs provide an important element of household services, such as health or education, and these expenditures are included in the individual consumption expenditure of government or NPISHs. However, in other economies, these same services are purchased by households from market producers and are included in the individual consumption expenditure of households. It follows that individual consumption expenditure of households does not capture all goods and services consumed by households in all economies. However, AIC covers all such goods regardless of whether they are purchased by households themselves or are provided as social transfers in kind by the government or NPISHs. The concept of actual individual consumption dates back to the earliest years of the ICP, when it was called the consumption expenditure of the population. Initially, the individual consumption expenditure by NPISHs was not included. Later, however, the concept was expanded to include the consumption expenditure of NPISHs, and it was adopted by national accountants in the System of National Accounts (SNA) 1993 (UNSC 1993). A separate PPP is calculated for individual consumption expenditure by households and for AIC. In addition, PPPs belonging to the following analytical categories were calculated on the basis of actual individual consumption: health; education; housing; water, electricity, and other fuels; recreation and culture; and miscellaneous goods and services.

A related aggregate called Total Consumption was published for the ICP 2021 results for the first time. It is the total value of actual and imputed final consumption expenditures incurred by households, NPISHs, and government on individual goods and services and final consumption expenditure of government on collective goods and services.