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Okun's Law Intuition suggests that if output growth is high, unemployment will decrease, and this is indeed true. This relation was first examined by U.S. economist Arthur Okun and for this reason has become known as Okun's law. FIG. 5 plots the change in the unemployment rate on the vertical axis against the rate of growth of output on the horizontal axis for the United States since 1960. It also draws the line that best fits the cloud of points in the figure. Looking at the figure and the line suggests two conclusions: The line is downward sloping and fits the cloud of points quite well. Put in economic terms: There is a tight relation between the two variables: Higher output growth leads to a decrease in unemployment. The slope of the line is -0.4. This implies that, on average, an increase in the growth rate of 1% decreases the unemployment rate by roughly -0.4%. This is why unemployment goes up in recessions and down in expansions. This relation has a simple but important implication: The key to decreasing unemployment is a high enough rate of growth. This line crosses the horizontal axis at the point where output growth is roughly equal to 3%. In economic terms: It takes a growth rate of about 3% to keep unemployment constant. This is for two reasons. The first is that population, and thus the labor force, increases over time, so employment must grow over time just to keep the unemployment rate constant. The second is that output per worker is also increasing with time, which implies that output growth is higher than employment growth. Suppose, for example, that the labor force grows at 1% and that output per worker grows at 2%. Then output growth must be equal to 3%11% + 2%2 just to keep the unemployment rate constant. As we shall see later in Section 8, the Phillips curve relation has evolved over time, in ways which cannot be captured in FIG. 6. This explains why the fit is not as good as, say, for Okun's law.
A low unemployment rate leads to an increase in the inflation rate, a high unemployment rate to a decrease in the inflation rate. Source: Series GDPCA,GDPA: Federal Reserve Economic Data (FRED) research.stlouisfed.org/fred2/. The Phillips Curve Okun's law implies that, with strong enough growth, one can decrease the unemployment rate to very low levels. But intuition suggests that, when unemployment becomes very low, the economy is likely to overheat, and that this will lead to upward pressure on inflation. And, to a large extent, this is true. This relation was first explored in 1958 by a New Zealand economist, A. W. Phillips, and has become known as the Phillips curve. Phillips plotted the rate of inflation against the unemployment rate. Since then, the Phillips curve has been redefined as a relation between the change in the rate of inflation and the unemployment rate. FIG. 6 plots the change in the inflation rate (measured using the CPI) on the vertical axis against the unemployment rate on the horizontal axis, together with the line that fits the cloud of points best, for the United States since 1960. Looking at the figure again suggests two conclusions: The line is downward sloping, although the fit is not as good as it was for Okun's law: Higher unemployment leads, on average, to a decrease in inflation; lower unemployment leads to an increase in inflation. But this is only true on average. Sometimes, high unemployment is associated with an increase in inflation. The line crosses the horizontal axis at the point where the unemployment rate is roughly equal to 6%. When unemployment has been below 6%, inflation has typically increased, suggesting that the economy was overheating, operating above its potential. When unemployment has been above 6%, inflation has typically decreased, suggesting that the economy was operating below potential. But, again here, the relation is not tight enough that the unemployment rate at which the economy overheats can be pinned down precisely. This explains why some economists believe that we should try to maintain a lower unemployment rate, say 4 or 5%, and others believe that it may be dangerous, leading to overheating and increasing inflation. Clearly, a successful economy is an economy that combines high output growth, low unemployment, and low inflation. Can all these objectives be achieved simultaneously? Is low unemployment compatible with low and stable inflation? Do policy makers have the tools to sustain growth, to achieve low unemployment while maintaining low inflation? These are the questions we shall take up as we go through the guide. The next two sections give you the road map. 5. The Short Run, the Medium Run, and the Long Run What determines the level of aggregate output in an economy? Consider three answers: Reading newspapers suggests a first answer: Movements in output come from movements in the demand for goods. You probably have read news stories that begin like this: "Production and sales of automobiles were higher last month due to a surge in consumer confidence, which drove consumers to showrooms in record numbers." Stories like these highlight the role demand plays in determining aggregate output; they point to factors that affect demand, ranging from consumer confidence to government spending to interest rates. But, surely, no amount of Indian consumers rushing to Indian showrooms can in crease India's output to the level of output in the United States. This suggests a second answer: What matters when it comes to aggregate output is the supply side- how much the economy can produce. How much can be produced depends on how advanced the technology of the country is, how much capital it is using, and the size and the skills of its labor force. These factors--not consumer confidence--are the fundamental determinants of a country's level of output. The previous argument can be taken one step further: Neither technology, nor capital, nor skills are given. The technological sophistication of a country depends on its ability to innovate and introduce new technologies. The size of its capital stock depends on how much people have saved. The skills of workers depend on the quality of the country's education system. Other factors are also important: If firms are to operate efficiently, for example, they need a clear system of laws under which to operate and an honest government to enforce those laws. This suggests a third answer: The true determinants of output are factors like a country's education system, its saving rate, and the quality of its government. If we want to understand what determines the level of output, we must look at these factors. You might be wondering at this point, which of the three answers is right? The fact is that all three are right. But each applies over a different time frame: In the short run, say, a few years, the first answer is the right one. Year-to-year movements in output are primarily driven by movements in demand. Changes in demand, perhaps as a result of changes in consumer confidence or other factors, can lead to a decrease in output (a recession) or an increase in output (an expansion). In the medium run, say, a decade, the second answer is the right one. Over the medium run, the economy tends to return to the level of output determined by supply factors: the capital stock, the level of technology, and the size of the labor force. And, over a decade or so, these factors move sufficiently slowly that we can take them as given. In the long run, say, a few decades or more, the third answer is the right one. To understand why China has been able to achieve such a high growth rate since 1980, we must understand why both the capital stock and the level of technology in China are increasing so fast. To do so, we must look at factors like the education system, the saving rate, and the role of the government. This way of thinking about the determinants of output underlies macroeconomics, and it underlies the organization of this guide. 6. A Tour of the Guide The guide is organized in three parts: A core; two extensions; and, finally, a comprehensive look at the role of macroeconomic policy. This organization is shown in FIG. 7. We now describe it in more detail. Core The core is composed of three parts-the short run, the medium run, and the long run. Sections 3 to 6 look at how output is determined in the short run. To focus on the role of demand, we assume that firms are willing to supply any quantity at a given price. In other words, we ignore supply constraints. Section 3 shows how the demand for goods determines output. Section 4 shows how monetary policy determines the interest rate. Section 5 puts the two together, by allowing demand to depend on the interest rate, and then showing the role of monetary and fiscal policy in determining output. Section 6 extends the model by introducing a richer financial system, and using it to explain what happened during the recent crisis. Sections 7 to 9 develop the supply side and look at how output is determined in the medium run. Section 7 introduces the labor market. Section 8 builds on it to derive the relation between inflation and unemployment. Section 9 puts all the parts together, and shows the determination of output, unemployment, and inflation both in the short and the medium run. Sections 10 to 13 focus on the long run. Section 10 introduces the relevant facts by looking at the growth of output both across countries and over long periods of time. Sections 11 and 12 discuss how both capital accumulation and technological progress determine growth. Section 13 looks at the interaction among technological progress, wages, unemployment, and inequality. Extensions The core sections give you a way of thinking about how output (and unemployment, and inflation) is determined over the short, medium, and long run. However, they leave out several elements, which are explored in two extensions: Expectations play an essential role in macroeconomics. Nearly all the economic decisions people and firms make depend on their expectations about future income, future profits, future interest rates, and so on. Fiscal and monetary policies affect economic activity not only through their direct effects, but also through their effects on people's and firms' expectations. Although we touch on these issues in the core, Sections 14 to 16 offer a more detailed treatment and draw the implications for fiscal and monetary policy. The core sections treat the economy as closed, ignoring its interactions with the rest of the world. But the fact is, economies are increasingly open, trading goods and services and financial assets with one another. As a result, countries are becoming more and more interdependent. The nature of this interdependence and the implications for fiscal and monetary policy are the topics of Sections 17 to 20. Back to Policy Monetary policy and fiscal policy are discussed in nearly every section of this guide. But once the core and the extensions have been covered, it is useful to go back and put things together in order to assess the role of policy. Section 21 focuses on general issues of policy, whether macroeconomists know enough about how the economy works to use policy as a stabilization tool at all, and whether policy makers can be trusted to do what is right. Sections 22 and 23 return to the role of fiscal and monetary policies. Epilogue Macroeconomics is not a fixed body of knowledge. It evolves over time. The final section, Section 24, looks at the history of macroeconomics and how macroeconomists have come to believe what they believe today. From the outside, macroeconomics sometimes looks like a field divided among schools--"Keynesians," "monetarists," "new classicals," "supply-siders," and so on-hurling arguments at each other. The actual process of re search is more orderly and more productive than this image suggests. We identify what we see as the main differences among macroeconomists, the set of propositions that define the core of macroeconomics today, and the challenges posed to macroeconomists by the crisis. Summary We can think of GDP, the measure of aggregate output, in three equivalent ways: (1) GDP is the value of the final goods and services produced in the economy during a given period; (2) GDP is the sum of value added in the economy during a given period; and (3) GDP is the sum of incomes in the economy during a given period. Nominal GDP is the sum of the quantities of final goods produced times their current prices. This implies that changes in nominal GDP reflect both changes in quantities and changes in prices. Real GDP is a measure of output. Changes in real GDP reflect changes in quantities only. A person is classified as unemployed if he or she does not have a job and is looking for one. The unemployment rate is the ratio of the number of people unemployed to the number of people in the labor force. The labor force is the sum of those employed and those unemployed. Economists care about unemployment because of the human cost it represents. They also look at unemployment because it sends a signal about how efficiently the economy is using its resources. High unemployment indicates that the country is not using its resources efficiently. Inflation is a rise in the general level of prices-the price level. The inflation rate is the rate at which the price level increases. Macroeconomists look at two measures of the price level. The first is the GDP deflator, which is the average price of the goods produced in the economy. The second is the Consumer Price Index (CPI), which is the average price of goods consumed in the economy. Inflation leads to changes in income distribution, to distortions, and to increased uncertainty. There are two important relations among output, unemployment, and inflation. The first, called Okun's law, is a relation between output growth and the change in unemployment: High output growth typically leads to a decrease in the unemployment rate. The second, called the Phillips curve, is a relation between unemployment and inflation: A low unemployment rate typically leads to an increase in the inflation rate. Macroeconomists distinguish between the short run (a few years), the medium run (a decade), and the long run (a few decades or more). They think of output as being determined by demand in the short run. They think of output as being determined by the level of technology, the capital stock, and the labor force in the medium run. Finally, they think of out put as being determined by factors like education, research, saving, and the quality of government in the long run. Terms
Questions / Problems QUIZ 1. Using the information in this section, label each of the following statements true, false, or uncertain. Explain briefly. a. U.S. GDP was 32 times higher in 2014 than it was in 1960. b. When the unemployment rate is high, the participation rate is also likely to be high. c. The rate of unemployment tends to fall during expansions and rise during recessions. d. If the Japanese CPI is currently at 108 and the U.S. CPI is at 104, then the Japanese rate of inflation is higher than the U.S. rate of inflation. e. The rate of inflation computed using the CPI is a better index of inflation than the rate of inflation computed using the GDP deflator. f. Okun's law shows that when output growth is lower than normal, the unemployment rate tends to rise. g. Periods of negative GDP growth are called recessions. h. When the economy is functioning normally, the unemployment rate is zero. i. The Phillips curve is a relation between the level of prices and the level of unemployment. 2. Suppose you are measuring annual U.S. GDP by adding up the final value of all goods and services produced in the economy. Determine the effect on GDP of each of the following transactions. a. A seafood restaurant buys $100 worth of fish from a fisherman. b. A family spends $100 on a fish dinner at a seafood restaurant. c. Delta Air Lines buys a new jet from Boeing for $200 million. d. The Greek national airline buys a new jet from Boeing for $200 million. e. Delta Air Lines sells one of its jets to Jennifer Lawrence for $100 million. 3. During a given year, the following activities occur: i. A silver mining company pays its workers $200,000 to mine 75 pounds of silver. The silver is then sold to a jewelry manufacturer for $300,000. ii. The jewelry manufacturer pays its workers $250,000 to make silver necklaces, which the manufacturer sells directly to consumers for $1,000,000. a. Using the production-of-final-goods approach, what is GDP in this economy? b. What is the value added at each stage of production? Using the value-added approach, what is GDP? c. What are the total wages and profits earned? Using the income approach, what is GDP? 4. An economy produces three goods: cars, computers, and oranges. Quantities and prices per unit for years 2009 and 2010 are as follows: 2009 2010 Quantity Price Quantity Price Cars 10 $2000 12 $3000 Computers 4 $1000 6 $500 Oranges 1000 $1 1000 $1 a. What is nominal GDP in 2009 and in 2010? By what percentage does nominal GDP change from 2009 to 2010? b. Using the prices for 2009 as the set of common prices, what is real GDP in 2009 and in 2009? By what percent age does real GDP change from 2009 to 2010? c. Using the prices for 2010 as the set of common prices, what is real GDP in 2009 and in 2010? By what percent age does real GDP change from 2009 to 2010? d. Why are the two output growth rates constructed in (b) and (c) different? Which one is correct? Explain your answer. 5. Consider the economy described in Problem 4. a. Use the prices for 2009 as the set of common prices to compute real GDP in 2009 and in 2010. Compute the GDP deflator for 2009 and for 2010, and compute the rate of inflation from 2009 to 2010. b. Use the prices for 2010 as the set of common prices to compute real GDP in 2009 and in 2010. Compute the GDP deflator for 2009 and for 2010 and compute the rate of inflation from 2009 to 2010. c. Why are the two rates of inflation different? Which one is correct? Explain your answer. 6. Consider the economy described in Problem 4. a. Construct real GDP for years 2009 and 2010 by using the average price of each good over the two years. b. By what percentage does real GDP change from 2009 to 2010? c. What is the GDP deflator in 2009 and 2010? Using the GDP deflator, what is the rate of inflation from 2009 to 2010? d. Is this an attractive solution to the problems pointed out in Problems 4 and 5 (i.e., two different growth rates and two different inflation rates, depending on which set of prices is used)? (The answer is yes and is the basis for the construction of chained-type deflators. See the Super-Section to this section for more discussion.) 7. The Consumer Price Index The Consumer Price Index represents the average price of goods that households consume. Many thousands of goods are included in such an index. Here consumers are represented as buying only food (pizza) and gas as their basket of goods. Here is a representation of the kind of data the Bureau of Economic Analysis collects to construct a consumer price index. In the base year, 2008, both the prices of goods purchased and the quantity of goods purchased are collected. In subsequent years, only prices are collected. Each year, the agency collects the price of that good and constructs an index of prices that represents two exactly equivalent concepts. How much more money does it take to buy the same basket of goods in the cur rent year than in the base year? How much the purchasing power of money has declined, measured in baskets of goods, in the current year, from the base year? The data: In an average week in 2008, the Bureau of Economic Analysis surveys many consumers and determines that the average consumer purchases 2 pizzas and 6 gallons of gas in a week. The price per pizza and per gallon in subsequent years are found below. Prices change over time. Year Price of Pizzas Price of Gas 2008 $10 $3 2009 $11 $3.30 2010 $11.55 $3.47 2011 $11.55 $3.50 2012 $11.55 $2.50 2013 $11.55 $3.47 a. What is the cost of the consumer price basket in 2008? b. What is the cost of the consumer price basket in 2009 and in subsequent years? c. Represent the cost of the consumer price basket as an index number in the year 2008 to 2013. Set the value of the index number equal to 100 in 2008. d. Calculate the annual rate of inflation using the percent change in the value of the index number between each year from 2009 through 2013. You would find it helpful to fill in the table below Year Consumer Price Index 2008 = 100 Inflation rate 2008 100 2009 2010 2011 2012 2013 e. Is there a year where inflation is negative? Why does this happen? f. What is the source of inflation in the year 2011? How is that different than inflation in the years 2009 and 2010? g. I have 100 dollars in 2008. How many baskets of goods can I buy with $100 in 2008? If I have$100 in 2013, how many baskets can I buy with that money in 2013? What is the percentage decline in the purchasing power of my money? How does the percentage decline in the purchasing power of money relate to the change in the value of the price index between 2008 and 2013? h. From 2009 to 2011, the price of a pizza remains the same. The price of gas rises. How might consumers respond to such a change? In 2012, the price of gas falls. What are the implications of such changes in relative prices for the construction of the Consumer Price Index? i. Suppose the Bureau of Economic Analysis determines that in 2013, the average consumer buys 2 pizzas and 7 gallons of gas in a week. Use a spreadsheet to calculate the Consumer Price Index set equal to 100 in 2013 and moving back in time, using the 2013 basket in the years from 2008 to 2013. Fill in the table below: Year Consumer Price Index 2013 = 100 Inflation rate 2008 2009 2010 2011 2012 2013 100 Why are the inflation rates (slightly) different in part d. and part i? 8. Using macroeconomic relations: a. Okun's law stated that when output growth is higher than usual, the unemployment rate tends to fall. Explain why usual output growth is positive. b. In which year, a year where output growth is 2% or a year where output growth is -2%, will the unemployment rate rise more? c. The Phillips curve is a relation between the change in the inflation rate and the level of the unemployment rate. Using the Phillips curve, is the unemployment rate zero when the rate of inflation is neither rising nor falling? d. The Phillips curve is often portrayed as a line with a negative slope. In the text, the slope is about -0.5. In your opinion, is this a "better" economy if the line has a large slope, say -0.8, or a smaller slope, say -0.2? 9. Hedonic pricing As the first Focus box in this section explains, it is difficult to measure the true increase in prices of goods whose characteristics change over time. For such goods, part of any price increase can be attributed to an increase in quality. Hedonic pricing offers a method to compute the quality-adjusted increase in prices. a. Consider the case of a routine medical check-up. Name some reasons you might want to use hedonic pricing to measure the change in the price of this service. Now consider the case of a medical check-up for a pregnant woman. Suppose that a new ultrasound method is introduced. In the first year that this method is available, half of doctors offer the new method, and half offer the old method. A check-up using the new method costs 10% more than a check-up using the old method. b. In percentage terms, how much of a quality increase does the new method represent over the old method? (Hint: Consider the fact that some women choose to see a doctor offering the new method when they could have chosen to see a doctor offering the old method.) Now, in addition, suppose that in the first year the new ultrasound method is available, the price of check-ups using the new method is 15% higher than the price of check-ups in the previous year (when everyone used the old method). c. How much of the higher price for check-ups using the new method (as compared to check-ups in the previous year) reflects a true price increase of check-ups and how much rep resents a quality increase? In other words, how much higher is the quality-adjusted price of check-ups using the new method as compared to the price of check-ups in the previous year? In many cases, the kind of information we used in parts (b) and (c) is not available. For example, suppose that in the year the new ultra sound method is introduced, all doctors adopt the new method, so the old method is no longer used. In addition, continue to assume that the price of check-ups in the year the new method is introduced is 15% higher than the price of check-ups in the previous year (when everyone used the old method). Thus, we observe a 15% price increase in check ups, but we realize that the quality of check-ups has increased. d. Under these assumptions, what information required to compute the quality-adjusted price increase of check-ups is lacking? Even without this information, can we say any thing about the quality-adjusted price increase of check ups? Is it more than 15%? less than 15%? Explain. 10. Measured and true GDP Suppose that instead of cooking dinner for an hour, you decide to work an extra hour, earning an additional $12. You then purchase some (takeout) Chinese food, which costs you $10. a. By how much does measured GDP increase? b. Do you think the increase in measured GDP accurately reflects the effect on output of your decision to work? Explain. Explore Further 11. Comparing the recessions of 2001 and 2009. One very easy source for data is the Federal Reserve Bank of St. Louis FRED database. The series that measures real GDP is GDPC1, real GDP in each quarter of the year expressed at a seasonally adjusted annual rate (denoted SAAR). The monthly series for the unemployment rate is UNRATE. You can download these series in a variety of ways from this database. a. Look at the data on quarterly real GDP growth from 1999 through 2001 and then from 2007 through 2009. Which recession has larger negative values for GDP growth, the recession centered on 2000 or the recession centered on 2008? b. The unemployment rate is series UNRATE. Is the unemployment rate higher in the 2001 recession or the 2009 recession? c. The National Bureau of Economic Research (NBER), which dates recessions, identified a recession beginning in March 2001 and ending in November 2001. The equivalent dates for the next, longer recession were December 2007 ending June 2009. In other words, according to the NBER, the economy began a recovery in November 2001 and in June 2009. Given your answers to parts (a) and (b), do you think the labor market recovered as quickly as GDP? Explain. For more on NBER recession dating, visit www.nber.org. This site provides a history of recession dates and some discussion of their methodology. More Info If you want to learn more about the definition and the construction of the many economic indicators that are regularly reported on the news-from the help-wanted index to the retail sales index-two easy-to-read references are: The Guide to Economic Indicators, by Norman Frumkin, 3rd edition, M.E. Sharpe, 4th edition, New York, 2005. The Economist Guide to Economic Indicators, by the staff of The Economist, 6th edition, Bloomberg, New York, 2007. In 1995, the U.S. Senate set up a commission to study the construction of the CPI and make recommendations about potential changes. The commission concluded that the rate of inflation computed using the CPI was on average about 1% too high. If this conclusion is correct, this implies in particular that real wages (nominal wages divided by the CPI) have grown 1% more per year than is currently being reported. For more on the conclusions of the commission and some of the exchanges that followed, read Consumer Prices, the Consumer Price Index, and the Cost of Living, by Michael Boskin et al., Journal of Economic Perspectives, 1998, 12(1): pp. 3-26. For a short history of the construction of the National Income Accounts, read GDP: One of the Great Inventions of the 20th Century, Survey of Current Business, January 2000, 1-9. (bea.gov/scb/pdf/BEAWIDE/2000/0100od.pdf). For a discussion of some of the problems involved in measuring activity, read Katherine Abraham, "What We Don't Know Could Hurt Us; Some Reflections on the Measurement of Economic Activity," Journal of Economic Perspectives, 2005, 19(3): pp. 3-18. To see why it is hard to measure the price level and output correctly, read "Viagra and the Wealth of Nations" by Paul Krugman, 1998 (www.pkarchive.org/theory/viagra.html). (Paul Krugman is a Nobel Prize winner, and a columnist at the New York Times. His columns are opinionated, insightful, and fun to read.) Super-Section: The Construction of Real GDP and Chain-Type Indexes The example we used in the section had only one final good- cars-so constructing real GDP was easy. But how do we con struct real GDP when there is more than one final good? This Super-Section gives the answer. To understand how real GDP in an economy with many final goods is constructed, all you need to do is look at an economy where there are just two final goods. What works for two goods works just as well for millions of goods. Suppose that an economy produces two final goods, say wine and potatoes: In year 0, it produces 10 pounds of potatoes at a price of $1 a pound, and 5 bottles of wine at a price of $2 a bottle. In year 1, it produces 15 pounds of potatoes at a price of $1 a pound, and 5 bottles of wine at a price of $3 a bottle. Nominal GDP in year 0 is therefore equal to $20. Nominal GDP in year 1 is equal to $30. This information is summarized in the following table. Nominal GDP in Year 0 and in Year 1. The rate of growth of nominal GDP from year 0 to year 1 is equal to 1$30 - $202>1$202 = 50%. But what is the rate of growth of real GDP? Answering this question requires constructing real GDP for each of the two years. The basic idea behind constructing real GDP is to evaluate the quantities in each year using the same set of prices. Suppose we choose, for example, the prices in year 0. Year 0 is then called the base year. In this case, the computation is as follows: Real GDP in year 0 is the sum of the quantity in year 0 times the price in year 0 for both goods: 110 * $12 + 15 * $22 = $20. Real GDP in year 1 is the sum of the quantity in year 1 times the price in year 0 for both goods: 115 * $12 + 15 * $22 = $25. The rate of growth of real GDP from year 0 to year 1 is then 1$25 - $202>1$202, or 25%. This answer raises however an obvious issue: Instead of using year 0 as the base year, we could have used year 1, or any other year. If, for example, we had used year 1 as the base year, then: Real GDP in year 0 would be equal to 110 * $1 + 5 * $32 = $25. Real GDP in year 1 would be equal to 115 * $1 + 5 * $32 = $30. The rate of growth of real GDP from year 0 to year 1 would be equal to $5/$25, or 20%. The answer using year 1 as the base year would therefore be different from the answer using year 0 as the base year. So if the choice of the base year affects the constructed percentage rate of change in output, which base year should one choose? Until the mid-1990s in the United States--and still in most countries today--the practice was to choose a base year and change it infrequently, say, every five years or so. For example, in the United States, 1987 was the base year used from December 1991 to December 1995. That is, measures of real GDP published, for example, in 1994 for both 1994 and for all earlier years were constructed using 1987 prices. In December 1995, national in come accounts shifted to 1992 as a base year; measures of real GDP for all earlier years were recalculated using 1992 prices. This practice was logically unappealing. Every time the base year was changed and a new set of prices was used, all past real GDP numbers-and all past real GDP growth rates-were recomputed: Economic history was, in effect, rewritten every five years! Starting in December 1995, the U.S. Bureau of Economic Analysis (BEA)-the government office that produces the GDP numbers- shifted to a new method that does not suffer from this problem. The method requires four steps: Constructing the rate of change of real GDP from year t to year t + 1 in two different ways. First using the prices from year t as the set of common prices; second, using the prices from year t + 1 as the set of common prices. For example, the rate of change of GDP from 2006 to 2007 is computed by: (1) Constructing real GDP for 2006 and real GDP for 2007 using 2006 prices as the set of common prices, and computing a first measure of the rate of growth of GDP from 2006 to 2007. (2) Constructing real GDP for 2006 and real GDP for 2007 using 2007 prices as the set of common prices, and computing a second measure of the rate of growth of GDP from 2006 to 2007. Constructing the rate of change of real GDP as the average of these two rates of change. Constructing an index for the level of real GDP by linking-or chaining-the constructed rates of change for each year. The index is set equal to 1 in some arbitrary year. At the time this guide is written, the arbitrary year is 2009. Given that the constructed rate of change from 2009 to 2010 by the BEA is 2.5%, the index for 2010 equals 11 + 2.5%2 = 1.025. The index for 2010 is then obtained by multiplying the index for 2009 by the rate of change from 2009 to 2010, and so on. (You will find the value of this index-multiplied by 100-in the second column of Table B3 in the Economic Report of the President. Check that it is 100 in 2009 and 102.6 in 2010, and so on.) Multiplying this index by nominal GDP in 2009 to derive real GDP in chained (2009) dollars. As the index is 1 in 2009, this implies that real GDP in 2009 equals nominal GDP in 2009. Chained refers to the chaining of rates of change de scribed previously. (2009) refers to the year where, by construction, real GDP is equal to nominal GDP. (You will find the value of real GDP in chained (2009) dollars in the first column of Table B2 of the Economic Report of the President.) This index is more complicated to construct than the indexes used before 1995. (To make sure you understand the steps, construct real GDP in chained (year 0) dollars for year 1 in our example.) But it is clearly better conceptually: The prices used to evaluate real GDP in two adjacent years are the right prices, namely the average prices for those two years. And, because the rate of change from one year to the next is constructed using the prices in those two years rather than the set of prices in an arbitrary base year, history will not be rewritten every five years-as it used to be when, under the previous method for constructing real GDP, the base year was changed every five years. (For more details...) top of page Article Index Home |
