F07PRICE INDICES - 1 ECONOMICS 304L FALL 2007 HANDOUT ON...

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ECONOMICS 304L FALL 2007 HANDOUT ON PRICE INDICES Nominal GDP = GDP in current dollars Real GDP = GDP in constant dollars To calculate REAL GDP, you can use prices in a base year as weights . This is a fixed weight procedure because the weights used are the same for all years and are the prices that prevailed in the base year. PRODUCTION PRICE per unit YEAR 1 YEAR 2 YEAR 1 YEAR 2 Q1 Q2 P1 P2 P1Q1 P1Q2 P2Q1 P2Q2 __________________________________________________________________ Good A 6 11 $.50 $ .40 $3.00 $5.50 $2.40 $4.40 Good B 7 4 .30 1.00 2.10 1.20 7.00 4.00 Good C 10 12 .70 .90 7.00 8.40 9.00 10.80 Total 12.10 15.10 18.40 19.20 Nominal Nominal GDP Yr.1 GDP Yr. 2 If you looked only at NOMINAL GDP, which is what is in fact observed in the economy, nominal GDP has risen from $12.10 in Yr. 1 to 19.20 in Yr. 2. This is an increase of 58.7 percent. To find the increase, or % change in GDP between 2 years, nominal GDP Yr. 2 - nominal GDP Yr. 1 nominal GDP Yr. 1 X 100 19.20 - 12.10 12.10 X 100 .587 X 100 = 58.7% How can we sort out how much of this change is due to change in output and how much of this change is due to changes in prices? If we use yr. 1 as the base year, we use year 1 prices as weights. Then Real GDP in Yr. 1 is $12.10 and real GDP in Yr. 2. is 15.10. This is an increase of 24.8%. 1
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If we use yr. 2, as the base year, we use year 2 prices as weights. Then real GDP in Yr. 1 is 18.40 and real GDP in year 2 is 19.20. Real GDP has increased from $18.40 to 19.20. This is an increase of 4.3%. Note that nominal GDP = real GDP in the chosen base year . Note that the growth rate of real GDP is very sensitive to the choice of the base year. The new BEA procedure takes the geometric average between 24.8 and 4.3. For our
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F07PRICE INDICES - 1 ECONOMICS 304L FALL 2007 HANDOUT ON...

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