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
Expenditure on oranges = 200 × $0.50
Nominal GDP = $100 + $100
= $100
= $100
= $200
Now we will calculate nominal GDP for 2007
and compare
Expenditure on apples = 160 × $0.50
Expenditure on oranges = 220 × $2.25
Nominal GDP = $80 + $495
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.
= $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
Expenditure on oranges = 220 × $0.50
Nominal GDP = $80 + $495
Thus, real GDP increased from 2006 to
2007—but not by as much as nominal
GDP
= $160
= $110
= $270
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
Quantity
Price
Item
Apples
160
$1.00
Oranges
220
$0.50
Item
Quantity
Price
Apples
100
$0.50
Oranges
200
$2.25
•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]
The next step is to average
together the percentage increases
for 2006 and 2007. Thus we have:
35%  15%
 Re alGDP 
 25%
2
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.
US gross domestic product in nominal dollars
and chained (2000) dollars
9
This is an index number used
to track changes over time in
the cost-of-living experienced
by households
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.
1982-84 is the reference base period
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.
If man lived by bread
alone
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)×100
2006
2007
2008
$1.25
1.30
1.40
$1.25
1.25
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.
13
Hypothetical market basket used to develop
the consumer price index
(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 in
current year
=(1)×(4)
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
360.00
Product
Twinkies
Fuel oil
Cable TV
$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)
14
The CPI Market Basket
The BLS now revises the CPI market basket every 2 years
The Consumer Price Index (1982-84 = 100)
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2007
29.8
31.8
39.8
55.5
86.3
109.3
133.8
153.5
174.5
196.4
211.68
Source: Bureau of Labor Statistics
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
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
Quality Change Bias
Many items have undergone
qualitative improvements
over time. Cars, cameras,
and software are three
examples