San Beda University

College of Arts and Sciences

Department of Economics

Development
Economics: Theory and
Policy
DEVECON
Assistant Prof. C. B. Mendoza, Jr.
Department of Economics
50 Years of Excellence in Economics
 INTRODUCTION TO
DEVELOPMENT ECONOMICS
Conceptual and Theoretical Framework
of Economic Development

Department of Economics
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 OUTLINE
• What is economic development?
• Operational definition of economic development
• Synthesis of the operational definition of
economic growth
• Measure of economic growth
• International comparison of real per capita
income
• Purchasing power parity problem
• Purchasing power parity method
• Big Mac PPP
Department of Economics
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 Conceptual Framework:
Main Features of Scarcity’s Definition

1. Human wants are unlimited.

2. Limited means to satisfy human wants.
3. Alternative uses of scarce resources.
4. Efficient use of scarce resources.
5. Need for choice and optimization.

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 Conceptual Framework:
Features of the Modern Growth-Oriented
Definition
1. Growth-orientation. Economic growth is measured by the
change in national output over time. The definition says
that, Economics is concerned with determining the pattern
of employment of scarce resources to produce commodities
‘over time’. Thus, the dynamic problems of production have
been brought within the pure view of Economics.

2. Dynamic allocation of consumption. Similarly, under this

definition, Economics is concerned with the pattern of
consumption, not only now but also in the future. Thus, the
problem of dividing the use of income between present
consumption and future consumption has been brought
within the orbit of Economics.

Department of Economics
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 Conceptual Framework:
Features of the Modern Growth-Oriented
Definition
3. Distribution. The modern definition also concerns
itself with the distribution of consumption among
various persons and groups in a society. Thus, while
the problem of distribution is implicit in the earlier
definitions, the modern definition makes it explicit.
4. Improvement of resource allocation. The definition
also says that, Economics analyzes the costs and
benefits of improving the pattern of resource allocation.
Improvement of resource allocation and better
distributive justice are synonymous with economic
development. Thus, issues of development of a less
developed economy have also been made subjects of
the study of Economics.
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 Conceptual and Theoretical
Framework of Economic Development

What is Economic
Development?

Department of Economics
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 What is economic development?

Conceptualization of economic
development

Classical Economics (Adam Economic development is

Smith, David Ricardo, Thomas economic growth, and vice-
Robert Malthus, etc.) versa.

Economic growth (economic

development) depends on the
free market and
entrepreneurial spirit of private
persons.
Department of Economics
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 What is economic development?

Conceptualization of economic
development

Joseph Schumpeter Economic development is not

economic growth, and vice-
versa.
Economic growth is producing
more of the same product
using the same methods of
production.

Department of Economics
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 What is economic development?

Conceptualization of economic
development

Joseph Schumpeter Economic development is

dramatic, disruptive, and
distinct process characterized
by innovations.

It involves five innovation

processes.

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 What is economic development?

SCHUMPETER’S FIVE PROCESSESS OF DEVELOPMENT

Innovation in Innovation in
Innovation in
production sources of raw
products
methods materials

Innovation in
Innovation in
industrial
markets
organization

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 What is economic development?

Conceptualization of economic
development

Simon Kuznets Economic growth is not

economic development.

Economic development is
economic growth with
structural economic changes.

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 What is economic development?

IMPLICATIONS

Economic development is Economic growth is

economic growth with independent of economic
structural economic changes. development. (It is possible to
have growth w/out devp’t)

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 What is economic development?

IMPLICATIONS

Economic growth is economic Economic growth is

development with structural independent of economic
economic changes. development. (It is possible to
have growth w/out devp’t)
It is not possible to have
economic development
without economic growth.

Department of Economics
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 What is economic development?

Conceptualization of economic
development

Post-Kuznets Observation: Many countries

have achieved economic
growth with structural
economic changes BUT without
significant improvements in
standard of living and well-
being.

Department of Economics
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 What is economic development?
Conceptualization of economic
development

Post-Kuznets Economic development is not

limited to economic growth
and structural economic
changes.

Economic development
involves changes that are not
necessarily economic in nature.

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 What is economic development?

Conceptualization of
economic development

Post-Kuznets Economic development

implies more.

What else should we

consider?

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 What is economic development?

• Post-Kuznets
If economic development implies more
than EG and SEC, what should it take
into account?
• Two possible sources of insight
1. Development as freedom (Amartya Sen)
2. Social Doctrine of the Church

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 Conceptual and Theoretical
Framework of Economic Development
Development as Freedom
(Amartya Sen)

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 Development as Freedom
(Amartya Sen)
What does the process of Economic
Development involve?

Moving Towards
Escaping from
Substantive
Unfreedoms
Human Freedoms

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 Development as Freedom
(Amartya Sen)
What does the process of Economic
Development involve?

Escaping from Moving Towards

Unfreedoms Substantive
Human Freedoms

economic, political, social,

cultural, etc. deprivations Interrelated deprivations

Department of Economics
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 Development as Freedom
(Amartya Sen)
What does the process of Economic
Development involve?

Escaping from Moving Towards

Unfreedoms Substantive
Human Freedoms

economic, political, social, ability to avoid deprivations such as

cultural, etc. deprivations starvation, illiteracy, morbidity, etc

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 Development as Freedom
(Amartya Sen)
How can people escape from unfreedoms
and achieve substantive human freedoms?

What are the means to achieve substantive

human freedoms?

Department of Economics
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 Development as Freedom
(Amartya Sen)
What does the process of Economic
Development involve?

Escaping from Moving Towards

Unfreedoms Substantive
Human Freedoms

Department of Economics
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 Development as Freedom
(Amartya Sen)
What does the process of Economic
Development involve?

Escaping from Moving Towards

Unfreedoms Substantive
Human Freedoms

❖ High national income

❖ High per capita national income
❖ Structural economic changes,
❖ Technological progress
❖ Industrialization
❖ Similar positive and progressive events
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 Development as Freedom
(Amartya Sen)

✓ High national income Means to

✓ High per capita national income achieve
✓ Structural economic changes, economic devp’t
✓ Technological progress
✓ Industrialization Economic devp’t
✓ Similar positive and progressive is not limited to
events them.

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 Development as Freedom
(Amartya Sen)
What does the process of Economic
Development involve?

Escaping from Moving Towards

Unfreedoms Substantive
Human Freedoms

Economic development is
about expanding real or
substantive human
freedoms.

Department of Economics
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 Development as Freedom
(Amartya Sen)
What does the process of Economic
Development involve?

Escaping from Moving Towards

Unfreedoms Substantive
Human Freedoms

Authentic ends of economic

development

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 Conceptual and Theoretical
Framework of Economic Development

Social Doctrine of the

Church

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 Social Doctrine of the Churce

• Can economic development be bereft of

moral and ethical judgments?

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 Social Doctrine of the Churce

• Object of the economy: Development of wealth and

its progressive increase not only in quantity but
also in quality.

• The development of wealth and its progressive

increase can be morally correct or incorrect.

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 Social Doctrine of the Churce

• When is the development of wealth and its

progressive increase morally correct?

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 Social Doctrine of the Churce

• When is the development of

wealth and its progressive
increase morally correct?

When it contributes to the overall

development of man and society as a
whole

Department of Economics
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 Social Doctrine of the Churce

Not a mere process

Development of accumulation of
goods and services

Not a sufficient condition for

bringing about authentic
human happiness (even if
accumulation is for the
common good)

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 Social Doctrine of the Church

• Can economic development be separated

from moral and ethical considerations?

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 Social Doctrine of the Churce

Development is achieved through the

exercise of economic freedom.

a particular aspect of
human freedom in its
totality

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 Social Doctrine of the Churce

• Economic freedom should be placed at the service

of human freedom in its totality because it is a
particular aspect of human freedom.

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 Social Doctrine of the Churce

The core of human freedom in its

totality is ethical and moral.

Economic development, which is

achieved through the exercise of
economic freedom, can not be separated
from moral and ethical considerations.

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 Social Doctrine of the Churce

Economic
• moral Freedom • overall
• ethical development of
• accumulation of
man and society
goods and
services
Human
Freedom Development

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 Conceptual and Theoretical
Framework of Economic Development

Operational Definition of
Economic Development

Department of Economics
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 Operational Definition of
Economic Development

• Economic development is a long-term

rational process of economic growth with
progressive and multi-dimensional changes
that contribute to the expansion of
substantive human freedoms within the
context of man’s overall development and
the development of society as a whole.

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 Operational Definition of
Economic Development
• It is a sequence of events, actions, and gradual
changes that leads to results.

❖ Economic progress (better life, better living

conditions, improvement in welfare)
❖ Real or substantive human freedoms
❖ Overall development of man and society

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 Conceptual and Theoretical
Framework of Economic Development

Economic development
is a process

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 Economic development
is a process.

• Since economic development is a sequence

of events,
• it is driven by interdependent and causal forces
• it has prerequisites

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 Economic development
is a process.
PREREQUISITES OF
ECONOMIC DEVELOPMENT

JOHN KENNETH Good governance

GALBRAITH Popular literacy and
enlightenment
Social justice

Education
E.F. SCHUMACHER Discipline
Organization

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 Economic development
is a process.
PREREQUISITES OF ECONOMIC
DEVELOPMENT
National qualities:
HEINRICH PESCH Moral stamina
Intelligence
Spirit of venture
Inherent vitality

Psychological qualities:
Love of one’s own
country
Love of one’s own people

Department of Economics
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 Economic development
is a process of Economic Growth
• What is economic growth?
➢ Quantitative expansions in economic variables

a) National income or output

(extensive growth)
b) Per capita national income or
output (true economic growth)

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 Economic development
is a process of Economic Growth
By 2022 By 2040
(6 years from now) (23 years or one
generation from now)
21.6% 13-15%
Poverty rate reduced
Extreme poverty
(6 million Filipinos uplifted) eradicated
3,500 5,000 3,500
at least

11,000
USD USD USD USD
Increase in Gross National Increase in Gross National
Income (GNI) Income (GNI)
(Achieve upper-middle income status (Achieve high income status where
where Thailand and China are today) Malaysia and South Korea are today)

Vision for the Philippines

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 Economic development
is a process of Economic Growth

Department of Economics
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 Economic development
is a process of Economic Growth

Department of Economics
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 Economic development
is a process of Economic Growth

Department of Economics
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 Economic development
is a process of Economic Growth

GDP per Capita: USD 3,318.927 (2019)

Life expectancy: 71.16 years
Adult Literacy: 98.2
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 GDP per Capita (2018)
Philippines compared to its Asian Neighbors
80000

70000 Qatar, 68793.8

SGP, 64,581.0
USA, 62,794.0

60000

HKG, 48,676.0

50000

JPN, 39,290.0
EUU, 39,927.0 KOR, 31,362.8
40000

BRN, 31,628.3
30000

MYS, 11,373.2
20000
CHN, 9,770.8
THA, 7,273.6

10000 IDN, 3,893.6

PHL, 3,102.7
VNM, 2,566.6
LAO, 2,542.5
0
Department of Economics
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 Economic development
is a process of Economic Growth

• What is economic growth?

• Simon Kuznets: sustained increase in real

per capita or per worker product

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 Long-term rational process of
economic growth

Why?
Long-term process Requires sustained
increase in real
income and real per
capita income

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 Long-term rational process of
economic growth

Why?
Rational process Involves
a) Application and
advancement of
science and technology
b) Industrialization
c) Integration of the
economy

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 …with progressive and
multidimensional changes

Why?
With Changes have to be
embodied in the
process of economic
growth

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 …with progressive and
multidimensional changes

Why?
Progressive Gunnar Myrdal:

Development is the
upward movement of
society as a whole.

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 …with progressive and
multidimensional changes

Why?
Progressive to achieve the core values
and objectives of
development

What are these core values

and objectives?

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 …with progressive and
multidimensional changes
CORE VALUES OF OBJECTIVES OF
DEVELOPMENT DEVELOPMENT
(DENIS GOULET) (MICHAEL TODARO)
1. Self-sufficiency ( to 1. To widen the availability
meet one’s basic needs) and expand the
distribution of basic life
sustaining goods

Department of Economics
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 …with progressive and
multidimensional changes
CORE VALUES OF OBJECTIVES OF
DEVELOPMENT DEVELOPMENT
(DENIS GOULET) (MICHAEL TODARO)

1. Self-sufficiency ( to 1. To widen the

meet one’s basic needs) availability and expand
the distribution of basic
life sustaining goods
2. Self-esteem (to be a 2. To raise standards of
person) living

Department of Economics
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 …with progressive and
multidimensional changes
CORE VALUES OF OBJECTIVES OF
DEVELOPMENT DEVELOPMENT
(DENIS GOULET) (MICHAEL TODARO)

1. Self-sufficiency ( to meet 1. To widen the availability and

one’s basic needs) expand the distribution of
basic life sustaining goods

2. Self-esteem (to be a person) 2. To raise standards of living

3. Freedom from servitude (to 3. To expand the range of

be able to choose) economic and social choices
available to countries and
individuals

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 …with progressive and
multidimensional changes

Why?
Multidimensional changes Economic development
focuses on
a) the development of
society as a whole

b) the overall
development of man

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 …with progressive and
multidimensional changes
Implications
Economic Economic
development is multi- development is not
dimensional. just about the
sustained increase in
real per capita
Primary objective of
economic devp’t income.

Department of Economics
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 …with progressive and
multidimensional changes

Implications
Economic development is Economic development is
multi-dimensional. not just about the
sustained increase in real
per capita income.
Primary objective of
economic devp’t It is also about poverty,
income inequality, health,
nutrition, literacy, etc.

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 …with progressive and
multidimensional changes
Implications
Economic development is There is no general policy
multi-dimensional. prescription for economic
development.

It is important to take a
multi-disciplinary and
multi-paradigmatic
approach.

Department of Economics
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 …with progressive and
multidimensional changes
Implications

Economic development is Economic development

multi-dimensional. should be the concern of
every member of society.

It is not the sole

responsibility of
government.

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 Conceptual and Theoretical
Framework of Economic Development
Synthesis of the Operational Definition
of Economic Development

Department of Economics
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 Synthesis of the Operational
Definition of Economic Development

ANSWER

Is economic growth
economic development?

Department of Economics
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 Synthesis of the Operational
Definition of Economic Development

ANSWER

Is economic growth Yes, but economic

economic growth is a narrow
development? concept of economic
development.

In what sense?

Department of Economics
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 Synthesis of the Operational
Definition of Economic Development
WHY?

Economic growth is a Economic growth pertains

narrow concept of to quantitative economic
economic development. changes.

Could be Economic development,

economic and however, includes both
non-economic quantitative and
qualitative changes.

Department of Economics
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 Synthesis of the Operational
Definition of Economic Development

WHY?

Economic growth is a It has an enabling aspect.

crucial element of the
process of economic
development. It is the first physical
manifestation of the
possibilities of economic
development.

Department of Economics
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 Synthesis of the Operational
Definition of Economic Development

WHY?
Economic growth is a It is a necessary but
crucial element of the not sufficient
process of economic
condition for
development.
economic
development.

Department of Economics
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 Synthesis of the Operational
Definition of Economic Development

ANSWER

Is economic growth
independent of
economic
development?

(Note: Recall definition

of economic devp’t of
Kuznets.)
Department of Economics
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 Synthesis of the Operational
Definition of Economic Development

ANSWER

Is economic growth No, economic growth

independent of is not independent of
economic economic
development? development.

In what sense?

Department of Economics
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 Synthesis of the Operational
Definition of Economic Development

Why?

Economic growth is Sustained economic

not independent of growth requires prior
economic economic
development. development.

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 Conceptual and Theoretical
Framework of Economic Development

Measurement of
Economic Development

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 Measurement of Economic
Development

ANSWER
How do we measure
economic
development?

Department of Economics
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 Measurement of Economic
Development

ANSWER

How do we measure We need to have a basis

economic development? for our measure of
economic
development.

What is our basis?

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 Measurement of Economic
Development

How do we measure Basis: Operational

economic definition of economic
development? development

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 Measurement of Economic
Development

• Economic development is a long-term

rational process of economic growth with
progressive and multi-dimensional changes
that contribute to the expansion of
substantive human freedoms within the
context of man’s overall development and
the development of society as a whole.

Department of Economics
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 Measurement of Economic
Development

• Operational definition of economic

development implies that we need two
complementary measures.
1. measure of economic growth
2. measure of progressive and multi-dimensional
changes

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 Measurement of Economic
Development

Two possible 1. National income or

measures output

2. Per capita national

income or output

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 Measurement of Economic
Development
According to Nobel
Prize winner
Douglass North
Which measure shall 1. National income or
we use? output (measure of
extensive growth)

2. Per capita national

income or output
(measure of true
economic growth)
Department of Economics
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 Measurement of Economic
Development

Which measure shall we 1. National income or

use? output (measure of
extensive growth)

Most 2. Per capita national

preferred income or output
measure (measure of true
economic growth)

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 Measurement of Economic
Development
❖ Real per capita income (RPCY)
formula
(Y) ÷ (N)
---------------
(P)

❖ where Y is nominal GDP or GNP, N is

population, and P is price level

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 Measurement of Economic
Development
• Real per capita income (RPCY) formula

Y
RPCY (y) = ---------------
N x P

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 Measurement of Economic
Development

ANSWER

As far as real per capita

income is concerned,
what should be our focus?

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 Measurement of Economic
Development

ANSWER

As far as real per capita Growth of real per capita

income is concerned, income
what should be our focus?

How do we
measure this?

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 Measurement of Economic
Development
❖ Based on growth rate rules
❖ Rule 1: growth of product a x b
Gab = Ga + Gb
Gab = growth of a x b
Ga = growth of a
Gb = growth of b

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 Measurement of Economic
Development
❖Rule 2: growth of ratio a / b
Ga/b = Ga – Gb
Gab = growth of a / b
Ga = growth of a
Gb = growth of b

Department of Economics
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 Measurement of Economic
Development
• Real per capita income (RPCY) formula
Y
RPCY (y) = ---------------
N x P
Applying the growth rate rules, we get
Gy = GY – (GN + GP)
Gy = GY – GN - GP

Department of Economics
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 Measurement of Economic
Development
• Formula for the growth of RPCY
Gy = GY – (GN + GP)
Gy = GY – GN - GP
where:
Gy = growth of RPCY
GY = growth of nominal GDP or GNP
GN = population growth
GP = growth of the price level

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 Measurement of Economic
Development
VARIABLE SOURCE OF DATA
Growth of Real Per Philippine Statistics
Capita Income Authority (National
Accounts)
Growth of Nominal GDP Philippine Statistics
or GNP Authority (National
Accounts)
Growth of Population Philippine Statistics
Authority (National
Accounts)
Growth of the Price Level Philippine Statistics
Authority / BSP
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 Conceptual and Theoretical
Framework of Economic Development
International Comparison of Real
Per Capita Income (RPCY)

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 Exchange Rate Method

• STEPS IN DETERMINING RPCY USING THE EXCHANGE

RATE METHOD

• Determine the basket of goods and services

1

• Construct price indexes for the basket of goods and services

2

• Determine RPCY in the local currency

3

• Convert RPCY in the local currency to US$ using the World

4 Bank Atlas Conversion Method and Conversion Rate

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 Exchange Rate Method

• World Bank Atlas Conversion Rate

3-year average exchange rate adjusted
for differences in the inflation of the
country and the USA, UK, Japan, and
the Euro zone

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 Exchange Rate Method

World Bank Atlas Conversion Rate

3-year average exchange rate adjusted
for differences in the inflation of the
country and the USA, UK, Japan, and
the Euro zone

GDP deflator (ratio of

nominal GDP to real GDP)

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 Exchange Rate Method

WHY?

The exchange rate

method is
undesirable.

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 Exchange Rate Method

WHY?

The exchange rate It does not maintain

method is purchasing power
undesirable. parity (PPP Problem)

The exchange rate

fluctuates a lot.

Department of Economics
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 Conceptual and Theoretical
Framework of Economic Development

Purchasing Power
Parity (PPP)

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 Purchasing Power
Parity (PPP)
• Explanation # 1

• Which step in the determination of RPCY

using the exchange rate method gives rise
to the PPP problem?

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 Purchasing Power
Parity (PPP)
• STEPS IN DETERMINING RPCY USING THE EXCHANGE RATE
METHOD

• Determine a basket of goods and services

1

• Construct price indexes for the basket of goods and services

2

• Determine RPCY in the local currency

3

• Convert RPCY in the local currency to US$ using the World Bank
4 Atlas Conversion Method and Conversion Rate

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP)
• STEPS IN DETERMINING RPCY USING THE EXCHANGE RATE METHOD

• Determine the basket of goods and

1 services

• Construct price indexes for the basket of goods and services

2

• Determine RPCY in the local currency

3

• Convert RPCY in the local currency to US$ using the World

4 Bank Atlas Conversion Method and Conversion Rate

Department of Economics
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 Purchasing Power
Parity (PPP)
• Explanation # 1

• The basket of goods and services may differ from

one country to another.

• Some goods and services are cheaper to buy in

poor countries relative to rich countries.

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 Purchasing Power
Parity (PPP)

Possible
Explanations
Why are services Productivity
cheaper in poor explanation
countries?
Factor Proportions
explanation

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 Purchasing Power
Parity (PPP)

Consequences of Exaggerates
using the exchange differences between
rate method rich and poor
countries
Underestimates real
per capita GNP or
GDP of poor countries

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 Purchasing Power
Parity (PPP) Problem
• Explanation # 2
• The exchange rate takes into account traded
goods. It does not account for non-traded goods
that are important for economic development.

• Non-traded goods include infrastructure, health

services, educational facilities, and the like.

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 Purchasing Power
Parity (PPP) Problem

Consequences of Leads to inconsistent

using the exchange estimates of real per
rate method capita GNP or GDP

Leads to inconsistent
international
comparison of RPCY
over time
Department of Economics
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 Purchasing Power
Parity (PPP) Problem

ANSWER

What is the solution to

the PPP Problem?

Department of Economics
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 Purchasing Power
Parity (PPP) Problem

What is the Purchasing Power

solution to the PPP Parity Method
Problem?

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Problem
❖ What is the purchasing power
parity method?
It is a method of comparing RPCY
based on the idea that exchange rate
movements tend to be more volatile
than changes in price levels.

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Problem

• What is purchasing power parity?

It is the number of units of the local
currency required to buy the same
basket of goods and services that a
US$ can buy in the United States.

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Problem

❖What is purchasing power parity?

If a US$ can buy good A and good B in
the United States, how much would it
cost in Philippine pesos to buy the
same goods?

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Problem

Two general 1. Use the PPP conversion

procedures rate/ relative or parity
price.

2. Construct comparable
prices for a basket of
goods and services

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Problem
STEP 1
Use the PPP conversion rate /relative or
parity price)

reflects how many goods the local currency

can buy in the country instead of how many
dollars the local currency can buy in the
exchange rate market.

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Problem

• Relative or Parity price

local price of the good or service

------------------------------------------
US$ price of the same good or service

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Problem
• PPP formula

domestic currency expenditures

------------------------------------------------
local price / US $ price
Relative or parity price

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Problem
STEP 2
Construct comparable international
prices (known as international $ or
PPP$ prices) for a basket of goods and
services.

WHY?

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Problem
STEP 2
Construct comparable international prices (known as
international $ or PPP$ prices) for a basket of
goods and services.

WHY?
since the US$ does not reflect the tastes or
preferences of all nationalities.

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Problem
STEP 2
PPP formula

domestic currency expenditures

---------------------------------------
(local price ÷ international $ or PPP$ price)

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Method

Theoretical Basis of Theory of Purchasing

the PPP Method Power Parity (Gustav
Cassell)

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Method

What is the theory of In the long-run, the

purchasing power exchange rate should
parity? move towards a rate
that equalizes prices
of an identical basket
of goods and services.

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Method

What are the 1. The exchange rate will

basic ideas of the adjust to ensure that the
theory of dollar will buy as much in
purchasing power a foreign country as it
parity would at home.

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Method

What are the basic 1. The exchange rate will

ideas of the theory of adjust to ensure that the
purchasing power dollar will buy as much in a
parity foreign country as it would at
home.
2. The dollar should buy the
same quantity of goods and
services in all countries.

Department of Economics
50 Years of Excellence in Economics
 Purchasing Power
Parity (PPP) Method
• International comparison of per capita
income in PPP or international US$ was
initially done by Alan Heston and Robert
Summers (Univ. of Pennsylvania)

• International Comparison Program of the

UN produced the Penn World Tables or
the Heston-Summers data set.
Department of Economics
50 Years of Excellence in Economics
 Conceptual and Theoretical
Framework of Economic Development

BIG MAC PPP

Department of Economics
50 Years of Excellence in Economics
 BIG MAC PPP

• The PPP method is a tedious method of

comparing RPCY among countries.

• “Big Mac” PPP was introduced by the

magazine “The Economist”.

Department of Economics
50 Years of Excellence in Economics
 BIG MAC PPP

FEATURES
Big Mac PPP The basket of goods
and services is made
up of only the Big
Mac.

Department of Economics
50 Years of Excellence in Economics
 BIG MAC PPP

FEATURES

Big Mac PPP The basket of goods

and services is made
up of only the Big
Mac.
The relative or parity
price is based on the
local price and US$
price of the Big Mac.
Department of Economics
50 Years of Excellence in Economics
 BIG MAC PPP
• Implied PPP

Big Mac price (local price)

--------------------------------------------
---
Big Mac price (US$)

Department of Economics
50 Years of Excellence in Economics
 BIG MAC PPP
STATE OF THE
LOCAL CURRENCY

ACTUAL
IMPLIED PPP > EXCHANGE RATE OVERVALUED

ACTUAL
IMPLIED PPP EXCHANGE RATE UNDERVALUED
<
Department of Economics
50 Years of Excellence in Economics
 BIG MAC PPP
• By how much is the currency overvalued?

IMPLIED PPP __
----------------------------- 1 X 100
ACTUAL EX. RATE

Department of Economics
50 Years of Excellence in Economics
 BIG MAC PPP
• By how much is the currency undervalued?

IMPLIED PPP
__ X 100
1 -----------------------------
ACTUAL EX. RATE

Department of Economics
50 Years of Excellence in Economics