Question

a) Explain why the traditional fixed-weighted measure of real GDP is preferred to nominal GDP for assessing changes in an economy's production over time. b) Explain why a chain-weighted measure of real GDP is preferred to the traditional fixed-weighted measure of real GDP.

Answer 1

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Traditional fixed weighted measure of real GDP is preferred to nominal GDP for assessing changes in Economy in following ways :

The problem with using a base year to calculate real GDP (he., the traditional method) is that it does not account for the fact that people tend to change their spending patterns as relative prices fluctuate. Over time, people tend to increase their purchases of products whose relative prices have decreased and reduced their purchases of products whose relative prices have increased. To avoid biases and mistakes in calculating real GDP, the weights used to calculate real GDP should reflect these spending (and, therefore, production) changes_ If not, inaccuracies will occur, and the farther from the base year real GDP is calculated, the greater these errors will be.*

Because people substitute relatively inexpensive products for relatively expensive ones, the traditional method of calculating real GDP has the Following effects;

1. For products whose relative prices have fallen, their contribution to real GDP is overvalued for all years after the base year and undervalued for all years prior to the base year.

2. For products whose relative prices have increased, their contribution to real GDP is undervalued for all years after the base year and overvalued for all years prior to the base year.

and 2007 Multiplying the quantity of computers produced in 1995 by computer prices in 2000 understates the true value of computers in 1995, because computer prices in 2000 were relatively lower than in 1995. Similarly, multi-plying the quantity of computers produced in 2007 by computer prices in 2000 overstates their actual contribution to real GDP, because computer prices in 2000 were relatively higher than in 2007. Adding to this valuation bias is the fact that relatively more computers were sold in 2007 due to their relatively low price,

The chain-weighted method is attractive because it avoids using a base year's prices as weights for calculating real GDP in all other years. Rather, it takes a geometric average of one year's prices (i.e., the current year) and the previous year's prices, thereby continually moving forward the base year. Because the weights used to measure real GDP move with time, the chain-weighted method accounts for relative price changes and the resulting fluctuations in spending patterns.

An increasing number of countries has begun using the chain-weighted method for computing real GDP.. Among the nations that have made this switch are Australia, Canada, Greece, Poland, the Netherlands, New Zealand, Sweden, Switzerland, United Kingdom, and the United States

Chain- weighted measure of real GDP is preferred to the traditional fixed - weighted measure of real GDP in following ways

Under the old calculation method, the most recent base year was 1987. This meant that calculating real GDP in, say, 1994, was determined by: 1) how much the price of a particular good or service changed in relation to its price in 1987; and 2) how large a share it accounted for in relation to total GDP in 1987.

To counter this upward bias, the Commerce Department decided to estimate the quantity measure of GDP using a chain-weight system. Essentially, a chain-weight system differs from a fixed-weight system in that it measures output using current and previous year prices—something akin to a floating base year. For example, calculating chain-type GDP for 1994 is done using prices and quantities from 1993 and 1994.

The primary advantage of the chain-weight measure is that it allows for substitution effects overtime—that is, it accounts for changes in consumption and production patterns that occur from relative price changes. Another important advantage is that chain-type measures value output of final goods and services for any period in terms of what the structure of the economy was at the time. Under the old method, Commerce would effectively rewrite economic history every time it reconfigured the GDP accounts to a different base year.

Although the chain-weight measure of GDP depicts a more accurate portrayal of the business cycle, there are some drawbacks associated with using it. First, because of the way the chain-type measures are constructed, the components of GDP do not sum exactly to the total. In contrast, under the old method, GDP was the exact sum of its components. In percentage terms, however, this discrepancy is pretty small.

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