GDP1990 = Output1990 Prices1990 = $5,546.1 billion

GDP1994 = Output1994 Prices1994 = $6,736.9 billion

This appears to be a verysubstantial change in GDP over the course of 4 years. But can

some or all of the change in GDPbe accounted for by a change in prices?

Converting nominal GDP to real GDP using a price index

Price Quantity = Market Value of Output

.50 100 oranges

1.00 300 coconuts

8.00 2,000 pizzas

$16,350Year 1(base year)

Nominal GDP = Real GDP

.50 110 oranges

1.00 330 coconuts

8.00 2,200 pizzas

$17,985 Year 2(quantities increase 10%)

Nominal GDP increases, Real GDP increases

Price Quantity = Market Value of Output

.55 100 oranges

1.10 300 coconuts

8.80 2,000 pizzas

$17,985Year 3(prices increase by 10%)

Nominal GDP increases, Real GDP remains constant

To construct a priceindex, we measure

changes in the priceof a market basket like this

--only with many more items

The representative market basket

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:

19871994

19941994

19871994

1994

// PP

OP

PP

GDP

1987

1994

P

P

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

It follows from the above that:

1994

198719941994

19871994

1994

/ P

POP

PP

GDP

P1994 cancels out on the right,so we have:

1987199419871994

1994

/PO

PP

GDP

(1)Year

(2)GDP

(current Prices)

(3)Price Index(1987=100)

(4)=(2) (3)GDP (1987 prices)

1960 $515.3 26.0 $1,970.8

1980 2,708.0 71.7 3,776.3

1990 5,546.1 113.3 4,897.31994 6,736.9 126.1 5,342.3

ALL DATA IN BILLIONS

Implicit Price Deflator for GDP, 1962-97

Source: Economic Report of the President

Year

19971992198719821977197219671962

Imp

licit

GD

P D

eflato

r120

100

80

60

40

20

0

112

100

83

70

47

35

2624

GDP in the U.S., 1962-99

Source: Economic Report of the President

Year

19971992198719821977197219671962

Billion

s

10,000

9,000

8,000

7,000

6,000

5,000

4,000

3,000

2,000

1,0000

Nominal GDP

Real GDP

Chain-type indexes correctfor 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.

Price Quantity Spending

Apples $1 300 $300

Bread 2 100 200

$500

Year 1

Price Quantity Spending

Apples $2 200 $400

Bread 2.50 200 500

$900

Year 2

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

2.1500$

600$

500$

)2$200()1$200(

breadapples

Calculating the change in real GDP with Year 2 as the base year

06.1850$

900$

)50.2$100()2$300(

900$

breadapples

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 baseyear, then the change is only

6 percent.

To compute a chain-typeindex (CTI), we take a geometric

mean of the growth ratesfor the two years.

This is done using the following formula

13.113.11272.1106.12.1 CTI

Chain-type index for GDP, U.S. , 1989-97

Year GDP

1989 81.36

1990 88.27

1991 93.82

1992 100.00 1993 102.94

1994 111.41 1995 123.74 1996 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

•Secondhand sales

•The underground economy (legal and illegal)

No one knowsjust how big

the underground economy is.

Estimates have gone as high as

13% of “measured”GDP