Nominal and Real GDP
• Nominal GDP:?
• Real GDP:?
Real GDP and Price Index
PRICE INDEX(PI) = 100*(Price in year t)/(price in
base year)
Real GDP = (Nominal GDP)/(Prce index; inhundreds)
% Real GDP = % Nominal GDP - % Pirice
Index
Price Index = GDP Deflator
Real GDP and Price Index
CUP OF PRICE PER NOMINAL
YEAR PRICE INDEX REAL GDP
LATTES CUP GDP
2012 1000 $2
2013 1200 $3
2014 1800 $4
2015 1600 $5
PER CAPITA GDP
THE BUSINESS CYCLE
6
Measuring the Cost of Living
• Inflation (π)
• occurs when the economy’s overall price level is rising.
• Inflation Rate (π%)
• the percentage change in the price level from one time period to another.
THE CONSUMER PRICE INDEX
• The consumer price index (CPI) is a measure of the overall cost of the
goods and services bought by a typical consumer.
• The Bureau of Labor Statistics reports the CPI each month.
• It is used to monitor changes in the cost of living over time.
THE CONSUMER PRICE INDEX
• When the CPI rises, the typical family has to spend more dollars to
maintain the same standard of living.
How the Consumer Price Index Is
Calculated
• Fix the Basket: Determine what prices are most important to the
typical consumer.
• The Bureau of Labor Statistics (BLS) identifies a market basket of goods and
services the typical consumer buys.
• The BLS conducts monthly consumer surveys to set the weights for the prices
of those goods and services.
How the Consumer Price Index Is
Calculated
• Find the Prices: Find the prices of each of the goods and services in
the basket for each point in time.
How the Consumer Price Index Is
Calculated
• Compute the Basket’s Cost: Use the data on prices to calculate the
cost of the basket of goods and services at different times.
How the Consumer Price Index Is
Calculated
• Choose a Base Year and Compute the Index:
• Designate one year as the base year, making it the benchmark against which
other years are compared.
• Compute the index by dividing the price of the basket in one year by the price
in the base year and multiplying by 100.
Consumer Price Index(CPI)=100*(Spending current year)/(Spending base year)
How the Consumer Price Index Is
Calculated
How the Consumer Price
Index Is Calculated
• Compute the inflation rate: (π%)
The inflation rate is the percentage change in the price index from the
preceding period.
How the Consumer Price Index Is
Calculated
• The Inflation Rate (π%)
• The inflation rate is calculated as follows:
C P I in Y ear 2 - C P I in Y ear 1
In flatio n R ate in Y ear 2 = 100
C P I in Y ear 1
Calculating the Consumer Price Index and the
Inflation Rate: An Example
How the Consumer Price Index Is
Calculated
• Calculating the Consumer Price Index and the Inflation Rate: Another
Example
• Base Year is 2002.
• Basket of goods in 2002 costs $1,200.
• The same basket in 2004 costs $1,236.
• CPI = ($1,236/$1,200) 100 = 103.
• Prices increased 3 percent between 2002 and 2004.
FYI: What’s in the CPI’s Basket?
16%
Food and
beverages
17% 41%
Transportation Housing
Education and
6%
communication 6%
6% 4% 4%
Medical care
Other goods
Recreation Apparel and services
Copyright©2004 South-Western
Problems in Measuring the Cost of
Living
• The CPI is an accurate measure of the selected goods that make up
the typical bundle, but it is not a perfect measure of the cost of living.
Problems in Measuring the Cost of
Living
• Substitution bias
• Introduction of new goods
• Unmeasured quality changes
Problems in Measuring the Cost of
Living
• Substitution Bias
• The basket does not change to reflect consumer reaction to changes in
relative prices.
• Consumers substitute toward goods that have become relatively less expensive.
• The index overstates the increase in cost of living by not considering consumer
substitution.
Problems in Measuring the Cost of
Living
• Introduction of New Goods
• The basket does not reflect the change in purchasing power brought on by
the introduction of new products.
• New products result in greater variety, which in turn makes each dollar more valuable.
• Consumers need fewer dollars to maintain any given standard of living.
Problems in Measuring the Cost of
Living
• Unmeasured Quality Changes
• If the quality of a good rises from one year to the next, the value of a dollar
rises, even if the price of the good stays the same.
• If the quality of a good falls from one year to the next, the value of a dollar
falls, even if the price of the good stays the same.
• The BLS tries to adjust the price for constant quality, but such differences are
hard to measure.
Problems in Measuring the Cost of
Living
• The substitution bias, introduction of new goods, and unmeasured
quality changes cause the CPI to overstate the true cost of living.
• The issue is important because many government programs use the CPI to
adjust for changes in the overall level of prices.
• The CPI overstates inflation by about 1 percentage point per year.
The GDP Deflator versus the Consumer
Price Index
• The GDP deflator is calculated as follows:
N o m in al G D P
G D P d eflato r = 100
R eal G D P
The GDP Deflator versus the Consumer
Price Index
• The BLS calculates other prices indexes:
• The index for different regions within the country.
• The producer price index, which measures the cost of a basket of goods and
services bought by firms rather than consumers.
The GDP Deflator versus the Consumer
Price Index
• Economists and policymakers monitor both the GDP deflator and the
consumer price index to gauge how quickly prices are rising.
• There are two important differences between the indexes that can
cause them to diverge.
The GDP Deflator versus the Consumer
Price Index
• The GDP deflator reflects the prices of all goods and services
produced domestically, whereas...
• …the consumer price index reflects the prices of all goods and services
bought by consumers.
The GDP Deflator versus the Consumer
Price Index
• The consumer price index compares the price of a fixed basket of
goods and services to the price of the basket in the base year (only
occasionally does the BLS change the basket)...
• …whereas the GDP deflator compares the price of currently produced
goods and services to the price of the same goods and services in the
base year.
REAL and NOMINAL INCOME
• Real Income this year = Nominal Income this year/CPI this year(in
hundreds)
• Example: Nominal income 2023=$40.000
Nominal income 2024=$41.000
CPI(2023)=234.8
Base Year:1984 CPI(2024)=236.5
Real income(2023) =?
Real income(2024) =?
Is Inflation Bad?
• Expected Inflation:
• Unexpected Inflation:
Real (r%) and Nominal Interest (i%)
Rates
• Interest represents a payment in the future for a transfer of money in
the past.
Real (r%) and Nominal Interest (i%)
Rates
• The nominal interest (i%) rate is the interest rate usually reported
and not corrected for inflation (π%).
• It is the interest rate that a bank pays.
• The real interest rate (r%) is the nominal interest rate that is
corrected for the effects of inflation (π%).
Real (r%) and Nominal Interest (i%)
Rates
Nominal interest rate = Real interest rate + Expected Inflation
“Fisher’s Hypothesis”
The Costs of Inflation
■ Financial wealth is eroded
■ Savings are discouraged
■ Menu costs—resources are misallocated with rising prices
■ Inflation tax—wealth is redistributed from lenders to borrowers