Tuesday, December 31, 2013

The Penn Effect plays out in the BRICs: Inflation cuts into GDP gains as experienced by the people

There is a useful article in The Economist describing why the increase in the Gross Domestic Product (GDP) of a developing country overestimates the increase in purchasing power of the people of that country.

The Penn Effect: "countries with higher incomes consistently had higher prices of domestically produced goods (as measured by comparable price indices), when compared at market exchange rates."

A country can import some goods and services. However, you have to be physically present to get your hair cut, or to buy fresh bread, or to get your teeth cleaned. These are called "non-tradable". In a just country the people who perform these functions see their pay increase as the per capita GDP increases. while the cost of imported goods and services does not increase with per capita GDP. If you think about it, as the GDP of your country increases, you can buy proportionately more imported goods and services, but less than proportionately more non-tradable services. Essentially there is an inflation in the prices of some of the market basket of goods purchased by people in a country as its per capita GDP increases.

So the rise in per capita GDP overestimates the increase in real income of people. How does this work out. Here is a graph provided by The Economist:

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