In March 1776, exactly 250 years ago, Scottish economist Adam Smith published his work The Wealth of Nations, widely considered to be one of the most influential books on political economy. In this book he highlighted the fact that people often confuse the real wealth of a country (the ability to buy goods and services) with its nominal wealth. The idea is still relevant today, so let us have a closer look. If we rank the major South Asian countries by their per capita nominal GDP (size of the total economy in the local currency divided by the price of a dollar), the list goes as follows :
1. SriLanka : USD 4516
2. India : USD 3051
3. Bangladesh : USD 2960
4. Pakistan : USD 1710
5. Nepal : USD 1550
6. Afghanistan : USD 417
Many people assume that these numbers measure how poor or rich a country is. In particular, the average Sri Lankan is 50 percent wealthier than the average Indian, and the average Bangladeshi is 70 percent wealthier than the average Pakistani. This is not really true. The nominal GDP accurately measures the real wealth of a country only in an utopian world where there are no taxes or other barriers on tradable goods, and transportation costs are completely absent. In reality, Americans can not instantly transport themselves to India to get cheap haircuts, and South Asian countries often impose huge taxes on imported goods. So nominal GDP is a flawed yardstick if we want to compare different countries.
Here’s a simple puzzle based on this idea : What steps should the Indian government take if they want to increase the country’s per capita nominal GDP from USD 3000 to USD 6000 within this year?
At first glance, achieving this may seem unattainable, given that India’s economy is currently growing at a rate of 6-7 percent annually. However, once we realize that nominal GDP also depends on trade policies, it is easy to come up with strategies to make this happen. For instance, the Indian government could implement an extra import duty of Rs 45 per dollar on all imported goods while simultaneously offering a Rs 45 per dollar subsidy (through tax incentives, free land, etc.) for all exported products. This will reduce the price of the dollar from Rs 90 to Rs 45 and double India’s nominal GDP. It’s also easy to see that this will have no impact on the real economy. Since the USD isn’t utilized in local transactions, the domestic market will stay the same. The extra tax imposed on imports will be balanced by the decrease in the dollar’s value. Likewise, the lower dollar rate will be offset by subsidies provided in the export sector.
