 GDP 1990 = Output 1990  Prices 1990 = $5,546.1 billion  GDP 1994 = Output 1994  Prices 1994 = $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? Converting nominal GDP to real GDP using a price index

Price  Quantity = Market Value of Output oranges coconuts ,000 pizzas $16,350 Year 1 (base year) Nominal GDP = Real GDP oranges coconuts 8.002,200 pizzas $17,985 Year 2 (quantities increase 10%) Nominal GDP increases, Real GDP increases

Price  Quantity = Market Value of Output oranges coconuts ,000 pizzas $17,985 Year 3 (prices increase by 10%) Nominal GDP increases, Real GDP remains constant

To construct a price index, we measure changes in the price of 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:  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:

P 1994 cancels out on the right, so we have: ALL DATA IN BILLIONS

Chain-type indexes correct for the “substitution bias” inherent in “constant dollar” measures of real GDP.

þSuppose we use 1992 as our base year to compute real GDP in þComputer prices have decreased substantially since þHence if we measure the value of computers in 1999 at 1992 prices, we will overstate the actual growth of output of computers.

Year 1

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

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

Chain-type index for GDP, U.S., To compute the growth rate for, say, 1997: [150.82/134.03] -1 = or 12.5 percent Source: Bureau of Economic Analysis

Non-market economic activity Secondhand sales The underground economy (legal and illegal) No one knows just how big the underground economy is. Estimates have gone as high as 13% of “measured”GDP