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1994 Feature Article - "Real" Estimates in the National Accounts
This article was published in Australian Economic Indicators May 1994 issue on 2 May 1994.


Introduction

The function of the Australian national accounts is to provide a comprehensive and coherent summary of the economic activity of the nation. A central feature of the national accounts is the presentation of statistics which show the value of production, who has produced it, the income flowing from that production and the expenditure of that income over a period. The most prominent national accounts statistic is gross domestic product (GDP) which measures the total market value of goods and services produced in Australia over a period after deducting the cost of goods and services used up in the process of production (intermediate usage or consumption), but before deducting the consumption of fixed capital.

Three measures of GDP

By definition, the value of production in a period must equal the income earned from that production and the expenditure on the goods and services produced. This means that GDP can be derived using three different approaches:

GDP(P): the unduplicated value of all final goods and services produced in the domestic economy (i.e. total gross output less total intermediate usage of goods and services);

GDP(l): the sum of all incomes accruing to the factors of production from domestic production, including net indirect taxes;

GDP(E): the sum of all final expenditures, plus changes in stocks, plus exports of goods and services less imports of goods and services.

Constant price estimates

Constant price estimates of the Australian national accounts were first produced in the early 1960s. The main reason for their introduction was that values expressed in current price terms suffer from the deficiency that the prices underlying the money values are subject to change over time and therefore the growth rates measured in current price terms are a combination of volume and price change. For certain types of analysis it is useful to have measures which focus on the underlying volumes (i.e. measures with the direct effect of changes in prices removed). Essentially, constant price estimates may be thought of as being derived by expressing the value of each component transaction as the product of a price and quantity and by substituting each current price with the corresponding price in the base year. For example, the value of $3,000 of wheat can be expressed in terms of being 20 tonnes at $150 per tonne, or total rent paid in a month for a shop as $5,000, made up of 100 square metres of floor space at $50 per square metre. In these examples, the constant price estimate for each individual transaction clearly can be derived as the product of the quantity and the base year price by substituting that price for the current price. In practice, however, it is generally not possible to derive constant price estimates in this way and they are usually compiled by dividing the current price estimates by a price index.

The concept of constant price estimation, as discussed above, is one approach to the derivation of “real” estimates. Up until the mid 1980s constant price estimates were the only real estimates compiled by the ABS. At that time, a sharp fall in the exchange rate of the Australian dollar meant that, while the constant price estimates of gross domestic product were providing information (correctly) about movements in the volume of Australian production, they were not identifying the declining purchasing power of the foreign income generated by our exports. It was therefore necessary to produce an alternative real estimate of GDP which was a purchasing power rather than a volume indicator. This measure is discussed below, following a summary of the main issues involved in expressing income measures in real terms.

Real estimates of income measures

Unlike GDP(P) and GDP(E), the constituents of GDP(I) cannot be conceived uniquely as the product of a price and a quantity. While it can be argued that the wages paid to an individual are equal to the product of the number of hours worked and the hourly wage rate, many employees are not paid according to the number of hours worked; also, the supplements paid are generally independent of the number of hours worked. Moreover, from an employee’s perspective, changes in the value of wages and salaries are related more to changes in their purchasing power than to changes in an hourly wage rate. In addition, an employer will be more interested in changes in wage costs per unit of output than in the input measure represented by hours worked. As gross operating surplus is the residual flow of income to the owners of capital after the payment of labour costs and net indirect taxes, there is no way it can be conceived as the product of a price and a quantity. Accordingly, constant price estimates are only derived for the components of GDP(P) and GDP(E), although the theoretical equality of GDP(E) and GDP(l) permits the derivation of a proxy constant price estimate of GDP(l) in total.

Although constant price estimates are not directly affected by price changes, indirect economic effects (such as an increased volume of exports induced by a fall in export prices) will be reflected in constant price GDP. Even if the constant price value of production remains the same, it is possible for the purchasing power of that production to change because of external influences, such as a change in the terms of trade. During the first half of the 1980s, some commentators were using growth in constant price GDP as a proxy for the growth in Australia’s real income. While it had been a reasonable assumption to make for a number of years prior to 1985, the large fall in the Australian dollar in early 1985 led to a sharp decline in Australia’s terms of trade which invalidated this assumption. Therefore, in conjunction with the March quarter 1986 issue of Australian National Accounts, National Income and Expenditure (cat. no. 5206.0), the ABS published an estimate of the real income being generated in the economy. At that stage it was referred to as “constant price gross domestic product adjusted for the terms of trade effect”. It is now called “real gross domestic income”. The differences between real gross domestic income and constant price GDP(l) reflect the effects of changes in the terms of trade on the purchasing power of income earned from Australian exports. The following describes the main features of the estimation of real gross domestic in-come.

The terms of trade index is defined as the ratio of export prices to import prices. In the Australian national accounts, it is derived as the ratio of the implicit price deflator (IPD) for exports of goods and services and the IPD for imports of goods and services. The major impact of a change in the terms of trade is on the volume of imports Australia can purchase with the receipts from a particular volume of exports. For ex-ample, if there is a decline in the terms of trade through a rise in the price of imports relative to the price of exports, then the volume of imports Australia could purchase with the receipts from a fixed volume of exports would be reduced. As a result, the volume of goods and services available in Australia would be reduced even though the volume produced (i.e. constant price GDP) may not have changed.

The terms of trade and real gross domestic in-come

The effect on real gross domestic income of a fall in the terms of trade can be illustrated by a simple example. Assume that wheat is the only good produced in Australia. In year 1, there are 10 million tonnes of wheat produced, priced at $100 per tonne giving a total value of production of wheat of $1,000 million. Part of the wheat (30 per cent, worth $300 million) is exported while the rest is consumed within Australia. Imports in the same period consist only of diesel fuel (1 million kilolitres at $300 per kilolitre resulting in a total value of $300 million). These imports are used up entirely in the process of producing the wheat. Therefore, the value of GDP is $700 million ($1000 million of output less $300 million of inter-mediate usage).

Assume that the only change between year 1 and year 2 is a decline in the terms of trade as a result of a rise in the price of diesel from $300 to $360 per kilolitre. If year 1 is the base period then the IPD for exports will be 100.0 in both years while the IPD for imports will be 100.0 in year 1 and 120.0 in year 2. Thus, the terms of trade have declined from 100.0 to 83.3 between the two years. The same volume of wheat is produced, consumed domestically and exported and the same volume of petroleum is imported. In constant price terms, the expenditure side of the domestic production account in year 2 expressed in year 1 prices will be identical to that for year 1 because there is no change in any of the components or in total GDP at constant prices (all the underlying volumes are identical in both years). However, the expenditure side of the domestic production account for year 2 does change in current price terms. The expenditure side of the production account is shown in the following table:

	Current price values ($m)		Constant price values ($m)
	Year 1	Year 2	Year 1	Year 2
Private final consumption expenditure	700	700	700	700
Exports	300	300	300	300
less Imports	300	360	300	300
Gross domestic product	700	640	700	700

Real gross domestic income ($m)*
	Year 1	Year 2
Private final consumption expenditure	700	700
Exports	300	250
less Imports	300	300
Real gross domestic income	700	650
* Expressed in Year 1 prices

GRAPH 1. REAL GROSS DOMESTIC INCOME AND GDP(I) AT AVERAGE 1989-90 PRICES, TREND
Change from same quarter of previous year