1. 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 However, the price level rose by 9 percent.

2. 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.

3. Nominal GDP Calculation
To calculate nominal GDP in 2006, sum the expenditures on apples and oranges in 2006 as follows:
Expenditure on apples = 100 × $ = $100 Expenditure on oranges = 200 × $ = $100 Nominal GDP = $100 + $ = $200

4. Now we will calculate nominal GDP for 2007 and compare
Expenditure on apples = 160 × $ = $80 Expenditure on oranges = 220 × $ = $495 Nominal GDP = $80 + $ = $575
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.

5. “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.

6. Traditional method: measuring 2007 GDP at 2006 prices
Expenditure on apples = 160 × $ = $160 Expenditure on oranges = 220 × $ = $110 Nominal GDP = $80 + $ = $270
Thus, real GDP increased from 2006 to 2007—but not by as much as nominal GDP

7. New Method of Calculating Real GDP
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
Item
Quantity
Price
Apples
100
$0.50
Oranges
200
$2.25
Item
Quantity
Price
Apples
160
$1.00
Oranges
220
$0.50
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]

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

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

10. Consumer Price Index (CPI)
This is an index number used to track changes over time in the cost-of-living experienced by households

11. The Consumer Price Index (CPI)
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.
is the reference base period

12. 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
If man lived by bread alone
Hypothetical example of a price index, base year 2006
Year
(1)
Price of Bread
in Current Year
(2)
in Base Year
(3)
Price index
=(1)/(2)×100
2006
2007
2008
$1.25
1.30
1.40
1.25
100
104
112
The price index equals the price in the current year divided by the price in the base year, all multiplied by 100.

14. 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
=(1)×(2)
(4)
current year
(5)
Basket in
=(1)×(4)
Twinkies
Fuel oil
Cable TV
365 packages
500 gallons
12 months
$0.89/package
1.00/gallon
30.00/month
$324.85
500.00
360.00
$0.79
1.50
30.00
$288.35
750.00
$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)

15. The CPI Market Basket
The BLS now revises the CPI market basket every 2 years

17. The Consumer Price Index (1982-84 = 100)
Source: Bureau of Labor Statistics

18. Sources of Bias in the CPI
Some economists have complained that the CPI does not accurately measure changes in the cost-of-living. They cite the following problems
New goods bias
Quality change bias
Commodity substitution bias
Outlet substitution bias

19. New Goods Bias
Think 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

20. Quality Change Bias
Many items have undergone qualitative improvements over time. Cars, cameras, and software are three examples