Do cross-country comparisons of GDP per capita using exchange rates understate true differences in living standards?
FALSE — they OVERSTATE differences
Why?
Exchange rates ignore differences in price levels across countries
Non-traded goods and services (e.g. food, rent, haircuts) are much cheaper in poorer countries
Therefore, income in poorer countries has greater purchasing power than exchange rates suggest
Implication:
Poor countries appear poorer than they really are
Rich countries appear relatively richer
Example:
India: ~$820 per capita
UK: ~$40,660 per capita
→ Looks like a 50× gap
→ ❌ Overstated because prices are much lower in India
Solution: PPP (Purchasing Power Parity)
Adjusts for price differences across countries
Uses a common set of prices
Provides a more accurate comparison of living standards
ONE-LINE SUMMARY (EXAM GOLD):
Exchange rate comparisons overstate international differences in living standards because they ignore lower prices in poorer countries; PPP provides a more accurate measure.
