Accounting for Price Changes

GDP measures the value of output in nominal dollars—that is, dollar values

at the time production took place. GDP rose by 9 percent between 1979

and 1980. However, the price level rose by 9 percent.

Real versus Nominal GDP

•We use money to measure the market value of new goods and services produced in the economy.

•The value (or purchasing power) of money is subject to change over time.

•Hence we need to adjust nominal GDP (that is, GDP measured at current prices) for changes in the value of money.

•GDP adjusted for changes in the value of money is called real GDP.

Nominal GDP Calculation

To calculate nominal GDP in 2006, sum the expenditures on apples and oranges in 2006 as follows:

Expenditure on apples = 100 × $1 = $100Expenditure on oranges = 200 × $0.50 = $100

Nominal GDP = $100 + $100 = $200

Our problem is that the nominal GDP figures do not give us an

accurate read of period-to-period changes in actual production.

Notice that a part of the change in nominal GDP from 2006 to

2007 resulted from a change in prices.

Now we will calculate nominal GDP for 2007 and compare

Expenditure on apples = 160 × $0.50 = $80Expenditure on oranges = 220 × $2.25 = $495

Nominal GDP = $80 + $495 = $575

“Traditional” Real GDP calculation

The traditional method converts nominal GDP to real GDP by measuring GDP in all periods at “base period prices”

To correct for changes in the value of money , we will

establish 2006 as our base year. That is, we will

measure 2007 output at 2006 prices.

Traditional method: measuring 2007 GDP at 2006 prices

Expenditure on apples = 160 × $1.00 = $160

Expenditure on oranges = 220 × $0.50 = $110Nominal GDP = $80 + $495 = $270

Thus, real GDP increased from 2006 to 2007—but not by as much as nominal GDP

New Method of Calculating Real GDP

ItemQuantit

y Price

Apples 160 $1.00

Oranges 220 $0.50

Item Quantity Price

Apples 100 $0.50

Oranges 200 $2.25

To use this method, we must value 2006 output at 2007 prices and 2007 output at 2006 prices.

2007 Quantities and 2006 Prices 2006 Quantities and 2007 Prices

•Measured at 2006 prices, Real GDP increased by 35% from 2006 to 2007 [($70/$200) × 100]

•Measured at 2007 prices, real GDP increased by 15% from 2006 to 2007 [($75/$500) × 100]

%252

%15%35Re

alGDP

Therefore, since real GDP in 2006 is $200, this chain-weighted method of converting nominal to real GDP gives us real GDP in 2007 of $250.

The next step is to average together the percentage increases for 2006 and 2007. Thus we have:

9

US gross domestic product in nominal dollars and chained (2000) dollars

Consumer Price Index (CPI)

This is an index number used to track changes over time in the cost-of-living experienced

by households

The CPI is the “narrow” price index in that the market basket used to construct it includes items purchased by households.Bureau of Labor Statistics economic assistants check the prices of 80,000 items in 87 metropolitan areas each month. 1982-84 is the reference base period

The Consumer Price Index (CPI)

THE CONSUMER PRICE INDEX

• Calculating the CPI– The CPI calculation has three steps:

• Find the cost of the CPI basket at base period prices.• Find the cost of the CPI basket at current period prices.• Calculate the CPI for the base period and the current

period.

13

Hypothetical example of a price index, base year 2006

Year

(1)Price of Bread

in Current Year

(2)Price of Bread in Base Year

(3)Price index

=(1)/(2)×100200620072008

$1.251.301.40

$1.251.251.25

100104112

The price index equals the price in the current year divided by the price in the base year, all multiplied by 100.

If man lived by bread alone

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Hypothetical market basket used to develop the consumer price index

Product

(1)Quantity in

market basket

(2)Prices in

base year

(3)Cost of

Basket in base year

=(1)×(2)

(4)Prices in

current year

(5)Cost of

Basket incurrent year

=(1)×(4)TwinkiesFuel oilCable TV

365 packages500 gallons12 months

$0.89/package1.00/gallon

30.00/month

$324.85 500.00 360.00

$0.79 1.50

30.00

$288.35 750.00 360.00

$1,184.85 $1,398.35

The cost of a market basket in the current year, shown at the bottom of column (5), sums the quantities of each item in the basket, shown in column (1), times the price of each item in the current year, shown in column (4)

The CPI Market Basket

The BLS now revises the CPI market basket every 2 years

1960 29.81965 31.81970 39.81975 55.51980 86.31985 109.31990 133.81995 153.52000 174.52005 196.42007 211.68

Source: Bureau of Labor Statistics

The Consumer Price Index (1982-84 = 100)

Sources of Bias in the CPI

•New goods bias•Quality change bias•Commodity substitution bias•Outlet substitution bias

Some economists have complained that the CPI does not accurately

measure changes in the cost-of-living. They cite the following problems

New Goods BiasThink of all the stuff you buy today that was not

around just 20 years ago

•Personal computers and software•Satellite TV•Cell phone service•High-speed internet service•Laser eye surgery•Digital music players•Serotonin reuptake inhibitors

Quality Change Bias

Many items have undergone qualitative improvements over time. Cars, cameras,

and software are three examples