Working with Chain-type Aggregates: A Few Tricks. Brent R. Moulton Bureau of Economic Analysis June 16, 2003

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1 Working with Chain-type Aggregates: A Few Tricks Brent R. Moulton Bureau of Economic Analysis June 16, 2003

2 What Is Real about Real GDP? Real GDP is intended to remove the effects of inflation in comparing GDP across time. The fundamental problem There is not a single inflation number Changes in relative prices Prior to 1996, BEA dealt with this problem by picking prices of a single base year - constant dollars

3 What Are Chain-type Measures? For each pair of periods (e.g., 2001 and 2002, or 2002-IV and 2003-I), calculate a Fisher index, which uses prices of both periods as weights. The quantity index is formed by chaining together these Fisher indexes for example: 100 F 1996,1997 F 1997,1998 To calculate chained-dollars, multiply quantity index times reference year current-dollar value, divided by 100.

4 What Were the Problems with Fixed-weight Constant Dollars? Substitution effect caused upward bias in recent periods as prices differ from greatly from baseyear prices Example: 2003Q1 GDP growth was 1.9% with current prices as weights (chained dollars), but was 3.5% with 1996 prices as fixed weights (constant dollars). Revisions due to updating base period -- rewrite of economic history.

5 Problems with Fixed-weight Constant Dollars For periods far from the base year, baseyear prices of little relevance. Examples: Should we measure real GDP for 1940s using prices of defense equipment in 1996? Should we measure growth in info processing equipment investment in 2003 using 1996 computer prices?

6 Common Errors in Using Chains Use of chained dollar values to measure share or contribution of component to GDP growth. Generally, the appropriate share of a component is its current-dollar share. = Measure of importance of the component relative to other components at prices of the period.

7 Measuring contributions Because chain-type measures use currentperiod prices as weights, the chained dollars (based on prices of the reference year) do not measure contribution to change. Solutions Use BEA s contributions to percent change, or Use approximation such as one described below.

8 Other problems Similar problems in measuring contribution or relative importance in chain-type price indexes. Issues arise from other calculations that implicitly assume additivity. For more examples, see Karl Whelan, Review of Income and Wealth, 2002.

9 Forecasting with Chains Often forecaster may forecast several components and wish to forecast their aggregate. Alternatively, could make a forecast of aggregates and wish to split it among components. Recommendation Don t forecast chaineddollar residual. There are better methods.

10 Example Goal: Forecast real nonresidential fixed investment for 2003:Q1. Assume forecaster knows (or has accurate forecasts of) 5 components structures, IP equipment & software, industrial equipment, transportation equipment, and other equipment. How bad will simple addition be?

11 Chained (1996) dollars 2002-IV 2003-I Nonresidential fixed investment 1, ,170.8 Pct change (annual rate) 2.3% -4.8% Structures Info processing eq & software Industrial equipment Transportation equipment Other equipment Sum 1, ,221.7 Pct change (annual rate) 2.8% -3.3%

12 Method 1 Fisher of Fishers Requires forecasts of price and quantity of each component. (Other methods will only require forecast of quantity) Emulates BEA s method. Step 1: Calculate Laspeyres index: Denominator: Last period current \$ value Numerator: Sum of this period s quantities valued at last period s prices.

13 Current dollars 2002-IV 2003-I Nonresidential fixed investment 1, ,105.1 Structures Info processing eq & software Industrial equipment Transportation equipment Other equipment

14 Laspeyres Denominator = 2002-IV current \$ total = \$1,117.1 Numerator, 2002-IV prices times 2003-I quantities: Structures: = IP eq. & soft: = Sum = = 1,103.4 Laspeyres = 1,103.4 / 1,117.1 =

15 Paasche Numerator is this period s current \$ value (sum of this period s prices times quantities). Denominator is sum of last period s quantities times this period s prices. Structures = = Sum = = 1,119.1 Paasche = 1,105.1 / 1,119.1 =

16 Fisher Fisher is square root of Laspeyres times Paasche. (geometric mean) Fisher = ( ) 1/2 = Multiply Fisher times last period s quantity to obtain (approximately) this period s chain-type quantity value. Forecast value of real nonresidential fixed investment = 1, = 1,170.6 (vs. 1,170.8 published)

17 What if you don t have prices? Can usually do well by just calculating the Laspeyres part of the example (relying on previous period s prices). Method 2 - Steps: Rebase quantities to 2002-IV prices Add 2003-I component values in chained (2002-IV) dollars Rebase total back to 1996 dollars.

18 Method 2 Convert component quantities to last period s prices: Structures: = IP eq. & software: = Sum the components: = 1,103.4 Convert back to 1996 dollars: 1,103.4 / = 1,170.6

19 Method 3 Calculate current-dollar share of each component for last period. Multiply share times percent change to get contribution Sum contributions to get aggregate percent change. Apply percent change to total.

20 Method 3 example Structures: = IP eq. & software: = Sum = = That is, real nonresidential fixed investment is forecast to decline 1.2 percent (qtrly rate) = 1, = 1,170.6

21 Summary It is possible to forecast chain-type aggregates with only a couple of additional steps over what was required for fixed-weight constant-dollar aggregates. Fisher of Fishers approach can be used to form user-defined aggregates (e.g., GDP less medical care) Not necessary to forecast residual For shares, use current dollars. For contributions, use BEA estimates or approximations shown here.

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