# THE TEACHING ECONOMIST - *William A. McEachern*

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# Issue 11, Spring 1996

*William A. McEachern, Editor *

#### New GDP Estimates

At the White House briefing on Clinton's proposed budget (C-SPAN, 2/5/96), Joe Stiglitz, head of the Council of Economic Advisors, appeared frustrated in trying to explain how the switch from fixed weights to chain weights resulted in lower estimates of GDP growth. He mentioned the impact of computer prices, but that only seemed to dig a deeper hole. He ended up saying how "technical" the change was and left it with that.

The next day I retrieved a transcript of the briefing from the White House's Internet page. As you read the transcript below, keep in mind that the audience is the White House press corps, a group for the most part statistically challenged, though probably no more so than principles of economics students.

: The [growth] numbers look low mainly because we've switched the accounting framework, the way we calculate the numbers-this is the new chain weighted numbers.Stiglitz

: What does that mean, chain-weighted?Question

: Well, the way it used to be -- let me explain how it used to be. It used to be that to calculate the GDP, you used the relative prices of a particular year -- that's a fixed weight-used 1987. And what happens is over time those relative weights that you associate with different goods get out of line. And there are periodic revisions -- 1987 -- then we were going to go to 1992 this year. But instead of doing this periodically, which causes lots of disruptions, what we're doing now is having what's called chain-weighted. So every -- you continually change the weights as time moves on. And when you do that, you get lower growth numbers. The main reason that numbers look lower than they did before was because of computers.Stiglitz

: Because of computers?Question

: Yes. The computer prices that were used were the '87 prices, and the computer prices have come down a lot. So when you bought a computer, they used the prices that computer would have bought if you could have bought it in 1987. So these are technical issues, but they do have a big effect on how you estimate GDP.Stiglitz

#### Technical, Indeed

*The Teaching Economist*will

*highlight the revision -- the most significant but the most complicated revision in four decades.*

As most know, for decades the Bureau of Economic Analysis (BEA) has estimated real GDP using a fixed-weight set of prices. Output has been weighted using prices in some base year-most recently 1987, so real GDP has been reported in "constant 1987 dollars." The main advantage of the fixed-weight system is its simplicity in calculating and reporting, not to mention ease of explanation in the classroom.

Using prices in a single base year yields accurate measures of real GDP as long as the year considered is close to the base year. But over time, relative prices in fact change and this change distorts the measure of output using fixed weights. Most notably, computer prices have fallen an average of 13% per year since 1982. As a result, real GDP estimates based on 1987 prices give computers too little weight before that date and too much weight thereafter. What's more, people tend to increase purchases of relatively cheaper goods and cut back on goods that become more expensive. This switching distorts even more the fixed-weight measure of output.

After delays caused by two federal government shutdown and fierce snowstorms, BEA has finally released details of its comprehensive revision of the national income and product account (NIPA). The most important change is moving from a fixed-weighted to a chain-weighted system. Annual changes in real GDP and in prices are "chain-type" measures based on the so-called "Fisher Ideal" formula that incorporates weights from two adjacent periods. The chain-type weighting system adjusts the weights more or less continuously, getting rid of much of the bias caused by a fixed system. BEA has adopted geometric averaging as the new method for calculating and reporting real GDP and its components. The geometric mean is found by multiplying the quantity index in, say, 1995 based on 1994 prices by the quantity index in 1995 based on 1995 prices, then taking the square root of that product.

Even though a chain-type index adjusts the weights from year to year, any index, by definition, must be anchored in some base year-that is, any index must answer the question "compared to what?" The BEA sets its quantity and price indexes equal to 100 in 1992, which then becomes the base year. Why 1992? The indexes are based in 1992 because that is the most recent year for which current-dollar estimates will not be subject to revision until the next comprehensive revision (in about five years from now).

In addition to calculating index numbers for quantities and prices,
BEA has also decided to provide dollar-denominated measures of
real GDP and its components, designated "*chained (1992)
dollars*," a term that seems ungainly now but will likely
become as familiar as "constant 1987 dollars." These
chain-weighted estimates are computed by multiplying the 1992
current-dollar value of GDP (or a GDP component) by the corresponding
quantity index number for the year in question. For example, the
current-dollar GDP in 1992 is $6,244.4 billion. The output index
increased from 100.0 in 1992 to 105.8 in 1994, so the chained
(1992) dollar estimate of real GDP in 1994 equals $6,244.4 billion
times 1.058, which is $6,604.2 billion (except for a tiny difference
because the index, as reported, is rounded).

Because the new formula uses the geometric mean of weights and
because each component of GDP is estimated separately, the chained
(1992) dollar estimates for the detailed GDP components do not
add up to the chained (1992) dollar estimates of GDP. Consequently,
BEA reports a *residual*, which is the difference between
real GDP and the sum of component estimates. For years close to
1992, this residual is tiny (for example, for 1990 and 1993 the
residual is only 0.01% of GDP). The residual grows as the year
moves further from 1992 (for example, in 1982 it was 1.42% of
GDP).

#### Other Revisions

The most important change (other than moving to chain weights) is an improved methodology for estimating depreciation -- the consumption of fixed capital. The change replaces straight-line depreciation patterns with new estimates based on the prices of used equipment and structures in resale markets. The total revision of depreciation is downward, with greater variability across different types of assets. This change affects current-dollar estimates for all years. Another major change is a redefinition of "government purchases" to "government consumption expenditures and gross investment." The new component now includes the consumption of government fixed capital.

#### New vs. Old Estimates

*Survey of Current Business*, which was published in early February. Revisions going back to 1959 are scheduled to appear in the January/February 1996

*Survey of Current Business*, which should appear by the time you receive this newsletter. Eventually, data series will be revised back to 1929, completing the most comprehensive revision in four decades. I was able to get GDP estimates back to 1959 from STAT-USA, the U.S. Commerce Department's on-line data service (the home page is http://www.stat-usa.gov/; the cost is $50 for three months). These estimates appear on the back page.

Compared to previously published figures, GDP estimates in current dollars have been revised up for all years; the average upward revision is 2.8%. The increase in current dollar estimates is due almost entirely to the new definition of government spending and an upward revision of personal consumption expenditures. The recognition of government investment raises GDP by including as expenditures the services of government fixed assets, measured as depreciation, or consumption of fixed capital.

Between 1959 and 1994, the revised estimates of real GDP show an average annual growth rate of 3.2%, compared to 3.0% for previously published estimates. The revision period can be sorted into two subperiods-before and after what had been the fixed-weight year of 1987. Between 1959 and 1987 the average annual growth rate in real GDP is now 3.4%, compared to 3.1% for previously published estimates. The upward revision in the growth of real was due primarily to the shift to the chain-type measure. Between 1987 to 1994, the average annual growth rate is now 2.3%, compared to 2.4% for previously published estimates.

During the most recent *completed* expansion, which began
in the third quarter of 1982 and ended in the second quarter of
1990, the average annual growth in real GDP is now 3.8%, which
is 0.3 percentage point higher than previously published estimates.
During the current expansion (from the first quarter of 1991
through the third quarter of 1995), the average annual growth
in real GDP is now 2.5%, which is 0.6 percentage point lower than
previously published estimates. So, compared to the fixed-weighted
estimates, the chain-weighted estimates show a stronger expansion
during the 1980s but a weaker current expansion.

I have only touched on some highlights of the revision. More detail is provided by studies referenced on the back page. But be forewarned, the chain-weighted approach is about three times more complicated than the current fixed-weight system. You will have to decide how much detail you want to get into in class, and how much you expect students to know. My own view is that in the principles course we might explain some intuition behind the new estimation procedure along with some implications of the new approach. But, given competing demands for the course (not to mention declining economics enrollments), a detailed examination of the new GDP estimation methodology may not reflect optimal use of scarce class time.