Analysis - Economic trends - Getting a measure of growth

The way the UK measures GDP has changed to better reflect economic reality, explains David Caplan.

The British economy is changing rapidly. As it changes, it becomes harder to measure. This September the Office for National Statistics introduced a number of improvements to the methods it uses for measuring the economy so that the published measures of economic activity better represent the economic reality.

How the economy is measured

You're probably familiar with gross domestic product, or GDP, as a measure of total economic activity. It measures the total production of goods and services within the economy which are not then used in producing other goods and services. So it includes spending by individuals and government, investment by companies and exports, but excludes spending on raw materials used making other products and services.

GDP can be expressed in three ways:

•   The sum of 'value added' for all those involved in productive activity.

•   The sum of all of the expenditures on goods and services less imports.

•   The sum of incomes generated by domestic production.

Each of these three ways of looking at economic activity leads to an approach to measuring GDP. In the UK, these are known as the output, expenditure and income approaches.

There are two key ways of expressing GDP - in nominal or 'current' prices or in 'real' or volume terms. In theory, although not always in practice, measuring GDP in current prices is relatively straightforward. Information on the components of GDP is collected and can then be added together to produce total GDP. However, many people are interested in GDP in volume terms - where the effects of price changes are removed to show underlying growth. Producing this makes things rather more complicated.

To illustrate the difficulties, let's take household consumption as an example. To estimate the change in the volume of spending on a particular product, the current price spending can be 'deflated' using a measure of price change such as a component of the Retail Price Index. However, to get a volume of spending on a combination of products, we need a common unit of measure - you can't add together the number of packets of cornflakes purchased to the number of widescreen televisions.

Statisticians get around this by expressing volumes in the price of a 'base' year. So, in the example the number of packets of cornflakes bought would be converted to a figure in pounds sterling representing how much it would have cost in a particular year. Using this approach enables all expenditure components in pounds in the prices of a fixed year to be added together.

Similarly on the output side, the volume of output of industries can be estimated by taking the value of output and revaluing using a price index such as a component of the Producer Price Index. The output of individual industries can then be weighted together using the industries' contribution to total economic activity in the base year.

There is no equivalent calculation for income data, which are only ever expressed in current prices.

In the past, official statisticians in the UK have used each year ending in '0' or '5' as base years, with the price base applying over a four to eight year period before being updated. The data at each different price base are linked together at a point where the data are calculated using two price bases.

This approach has worked well but has a clear drawback. If there is a change in the structure of economic activity, the price base is no longer appropriate for the estimation of total economic activity. The most dramatic example of this occurred in 1986 when, following the fall in the price of oil, the contribution of the oil and gas extraction industries to total UK output fell enormously. Less dramatic, but just as relevant, are the long-term changes in the structure of the UK economy. Unless the price base is regularly updated, it is likely that measures of growth will be distorted by using an out-of-date structure.

Statisticians have responded to this increased rate of change by developing annual chain-linking. Instead of rebasing every five years, growth is calculated using the prices of the previous year.

Annual chain-linking in the UK

Annual chain-linking was introduced to GDP and related statistics from the autumn of 2003. For GDP, both the expenditure and output approaches are now calculated using this method. Annual chain-linking has been carried out at as detailed a level as possible and the data go all the way back to 1949. Very detailed data are still calculated using five yearly chains - with the latest data now based on 2000.

The most recent base year is 2000, which means all data from 2001 onwards are aggregated using prices of 2000. This base year will be rolled forward by at least one year annually.

Users of the data shouldn't actually notice much difference. The tables in publications still look the same, although the phrase 'constant prices' has been replaced with 'chained-volume measures'. Additionally, expenditure components of GDP will only arithmetically equal the total in the period since the last base year as components and totals are chain-linked separately and linking factors for totals are not the same as for components.

Annual chain-linking should reduce the size of revisions to data. Changing structures will be incorporated quickly and the five-yearly upheaval due to rebasing will in future be avoided.

Other changes

A number of other changes were introduced in the data released in September.

Annual data from business inquiries was incorporated. Estimates of the impact of missing trader intra-community VAT fraud have also been introduced.

Alongside annual chain-linking, various other changes to deflation have been made. For imports and exports of goods, directly collected price information has now replaced less direct price estimates. For household consumption, more appropriate price measures were introduced for a number of commodities.

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