Thursday, March 29, 2007

Get Real!

Many applied econometric models based on aggregate time series data make use of expenditure, income or GDP series. Consumption functions, demand functions or even production functions, for example. It is important to recognise the need to use series that have been expressed at constant prices (relating to a suitable base year) rather than at the current prices ruling in each individual year. That is the series should be in real rather than nominal terms.

For example if you are modelling the total use of energy in the UK you may want to include real GDP as one of your explanatory variables, to indicate the overall level of economic activity in the economy. Using current price GDP figures would overstate the growth of real economic activity as it would include increases due to inflation as well as those due to actual economic activity. You will need a measure of GDP that has been deflated by dividing through by an appropriate measure of inflation – in this case the GDP deflator.

Often suitably deflated series are readily available in published form. For example the series with the code ABMI - UK Gross Domestic Product in £ million at constant 2003 prices - can now be downloaded directly from the UK National Statistics website. Go to, select Blue Book, select UK national and domestic product, and then pick out the ABMI series.

Sometimes you will have to find an appropriate price deflator for yourself to adjust a current price series for inflation. Here you will have to make sure that you are using the appropriate price deflator as there are many series that track inflation. The CPI (consumer price index) would be appropriate if you were looking at overall consumer expenditure but there will be occasions when some other price series such as the GDP deflator would be appropriate.

Implicit price series
The availability of expenditure series in both current and constant price form means that you will have the possibility of recovering an implicit price series for the expenditure category. For example if you have the two series FOODEXP and FOODEXP2005, where FOODEXP measures total expenditure on food each year at current prices while FOODEXP2005 is total expenditure on food at constant (2005) prices, then the index of food prices would be say PFOOD = FOODEXP/FOODEXP2005 (or you might like to multiply this by 100 so that the base year value of the series is 100 rather than 1). This of course would give you a measure of the nominal price of food rather than an index of the price of food in real terms. To get that you will have to divide your nominal price series by an overall price index for the economy.

Real interest rates
Another area where you might need to think about real rather than nominal values is with interest rates. Real interest rates are nominal (or market) interest rates minus the rate of inflation. If the rate of inflation in a country is quite high, then nominal interest rates would also have to be high in order to provide a real return for lenders.

You will also have to be careful to compute other series in real terms. For example you might need real wages, the real money supply or even a measure of real exchange rates. Make sure that you know how to do this!


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