Question

The income of poor countries is often understated when using the exchange-rate method of measuring per-capita income, as opposed to the PPP method

Answer 1

When countries' incomes are compared using the PPP method instead of the exchange rate method, income differences between developed countries and developing countries tend to become smaller.

Two methods of International Income Comparison are Exchange rate method and Purchasing Power Parity Method (PPP).

In Exchange rate method exchange rate is determined by flow of traded goods at international point of view.It does not take into account non traded goods. Using market exchange rate is not reliable when converting GDPs into dollars for international comparison because it is volatile- the supply and demand for it in foreign markets which can change because of monetary policy (increase in interest rates) or foreign speculation.

Purchasing Power Parity Method (PPP) uses an exchange rate to convert value of GDP of different countries into the same currency.To compare the GDP levels of two nations, we cannot rely on market exchange rates. PPP allows for more accurate comparisons. Economists use GDP per capita on a PPP basis in current international dollars.PPP adjustment thus corrects the national income for the cost of living. The purchasing power of a currency is determined by the differences in the relative cost of living. By equalising the cost of living, the purchasing power exchange rate equalises the two currencies' purchasing power. This means that the quantity of the currency needed to purchase a given unit of good can be determined and compared.

To conclude, PPP is a better and more accurate of measuring national income because purchasing power parity exchange rates are more reliable than market exchange rates because they are more stable and are unaffected by foreign currency speculation and by changes in monetary policy.