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Converting nominal GDP to real GDP using a price index GDP1990 = Output1990 Prices1990 = $5,546.1 billion GDP1994 = Output1994 Prices1994 = $6,736.9 billion This appears to be a very substantial change in GDP over the course of 4 years. But can some or all of the change in GDP be accounted for by a change in prices? Price Quantity = Market Value of Output .50 100 oranges 1.00 300 coconuts 8.00 2,000 pizzas $16,350 Year 1 (base year) Nominal GDP = Real GDP .50 110 oranges 1.00 330 coconuts 8.00 2,200 pizzas $17,985 Nominal GDP increases, Real GDP increases Year 2 (quantities increase 10%) Price Quantity = Market Value of Output .55 100 oranges 1.10 300 coconuts 8.80 2,000 pizzas $17,985 Year 3 (prices increase by 10%) Nominal GDP increases, Real GDP remains constant The representative market basket To construct a price index, we measure changes in the price of a market basket like this --only with many more items In the following illustration, 1987 is our base year--that is, we will express GDP in all other years in 1987 prices. The price index for 1994 is given by: P1994 P1987 If we divide GDP measured at current prices by the above price index, we obtain a measure of output in 1994 expressed in 1987 prices GDP1994 P1994 O1994 P1994 / P1987 P1994 / P1987 It follows from the above that: GDP1994 P1987 P1994 O1994 P1994 / P1987 P1994 P1994 cancels out on the right, so we have: GDP1994 O1994 P1987 P1994 / P1987 ALL DATA IN BILLIONS (4)=(2) (3) GDP (1987 prices) Year 1960 (2) (3) GDP Price Index (current Prices) (1987=100) $515.3 26.0 1980 2,708.0 71.7 3,776.3 1990 1994 5,546.1 6,736.9 113.3 126.1 4,897.3 5,342.3 (1) $1,970.8 Implicit Price Deflator for GDP, 1962-97 120 112 100 100 80 83 70 60 47 40 35 20 24 26 0 1962 1967 1972 1977 1982 1987 1992 Year Source: Economic Report of the President 1997 GDP in the U.S ., 1962-99 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Nom inal GDP 1962 1967 1972 1977 1982 1987 Yea r Source: Eco nomic Report o f the President 1992 1997 Real GDP Chain-type indexes correct for the “substitution bias” inherent in “constant dollar” measures of real GDP. Suppose we use 1992 as our base year to compute real GDP in 1999. Computer prices have decreased substantially since 1992. Hence if we measure the value of computers in 1999 at 1992 prices, we will overstate the actual growth of output of computers. Year 1 Price Quantity Spending Apples $1 300 $300 Bread 2 100 200 $500 Year 2 Price Quantity Spending Apples $2 200 $400 Bread 2.50 200 500 $900 Consumers have substituted bread for apples as a result of the relative price change Calculating the change in real GDP with Year 1 as the base year (200apples $1) (200bread $2) $600 1.2 $500 $500 Calculating the change in real GDP with Year 2 as the base year $900 $900 1.06 (300apples $2) (100bread $2.50) $850 If we use Year 1 is our base year, then real GDP growth from year 1 to year 2 is 20 percent. However, if Year 2 is our base year, then the change is only 6 percent. To compute a chain-type index (CTI), we take a geometric mean of the growth rates for the two years. This is done using the following formula CTI 1.2 1.06 1 1.272 1 1.13 1 .13 Chain-type index for GDP, U.S. , 1989-97 Year 1989 1990 1991 1992 1993 1994 1995 1996 GDP 81.36 88.27 93.82 100.00 102.94 111.41 123.74 134.03 1997 150.82 To compute the growth rate for, say, 1997: [150.82/134.03] -1 = 0.125 or 12.5 percent Source: Bureau of Economic Analysis •Non-market economic activity No one knows just how big the underground economy is. Estimates have gone as high as 13% of “measured”GDP •Secondhand sales •The underground economy (legal and illegal)