Download Price Quantity = Market Value of Output

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)