Intermediate Macroeconomic Theory

Nazmul Hoque
George Washington University
Chain weighted real GDP

Two major problems are associated with fixed-weight measures of real GDP – (1) economic growth may be
mismeasured due to substitution bias & (2) attempts to reduce this bias for recent years by periodically updating the
base year lead to revisions of historical growth rates.

Substitution bias arises because output and prices grow at different rates. The farther in time we move away from
the base year, the large is the difference between the fixed-price weights of the base year and the actual transaction
prices output. With fixed price weight, goods with higher output growth and slower price growth tend to receive
more weight than reflected in current prices. This leads to an upward bias in the rate of GDP growth that becomes
progressively worse overtime.

Fixed-weighted measures are additive, but chain-weighted measures are not. That is, components of chain-weighted
real GDP do not add up to real GDP.

How to calculate Chain-weighted RGDP

Suppose you want to calculate chain-weighted RGDP in year t with base year t-1.

Step 1:

First calculate growth rate using the following formula.

∑ 𝑃𝑡 𝑄𝑡 ∑ 𝑃𝑡−1 𝑄𝑡
𝑔𝑡 = (√ × − 1) × 100
∑ 𝑃𝑡 𝑄𝑡−1 ∑ 𝑃𝑡−1 𝑄𝑡−1

where 𝑃𝑘 is the price in year 𝑘, 𝑄𝑙 is the quantity in year 𝑙 and ∑ 𝑃𝑘 𝑄𝑙 is year 𝑙 GDP at year k prices. For example,
∑ 𝑃𝑡 𝑄𝑡−1 is GDP of year 𝑡 − 1 valued at price of year 𝑡.

Step 2:

Now calculate RGDP for year t using the following formula –

𝐑𝐆𝐃𝐏𝐭 = 𝐑𝐆𝐃𝐏𝐭−𝟏 × (𝟏 + 𝐠 𝐭 )

Example: Table 2.3 of ABC, chapter 2.

What is chain-weighted real GDP for year 2 with year 1 as the base year?

Year 1 Year 2
Production (quantity)
Computer 5 10
Bicycle 200 250
Price per unit
Computer 1200 600
Bicycle 200 240
GDP at Year 1 Price 46000 62000
GDP at Year 2 Price 51000 66000
 Intermediate Macroeconomic Theory

Nazmul Hoque
George Washington University
Step 1: Calculate Growth rate for year 2.

= 32.06%

Step 2: Calculate Real GDP for year 2.

𝐑𝐆𝐃𝐏𝟐 = 𝐑𝐆𝐃𝐏𝟏 𝐱(𝟏 + 𝐠 𝟐 )

= 46000(1+0.3206)

= 60747.6

So Real GDP in year 2 is 60747.6.

Chain weighted price index

Chain weighted price index uses the same approach as chain weighted real GDP.

∑ Pt Q t ∑ Pt Q t−1
𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥𝑡 = (√ × ) × 100
∑ Pt−1 Q t ∑ Pt−1 Q t−1

And Inflation rate is

∑ Pt Q t ∑ Pt Q t−1
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒t = (√ × − 1) × 100
∑ Pt−1 Q t ∑ Pt−1 Q t−1

Price Indext = Price Indext−1 × (1 + Inflation Ratet )

Example:

∑ P2 Q 2 ∑ P2 Q1 66000 51000
𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑑𝑒𝑥2 = (√ × ) × 100 = (√ × ) × 100 = 108.64
∑ P1 Q 2 ∑ P1 Q1 62000 46000

And Inflation Rate:

66000 51000
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒2 = (√ × − 1) × 100 = 8.64%
62000 46000

Price Index2 = 100 × (1 + 8.64%) = 108.64