Nominal GDPFor 2013 GDP we use prices paid in 2013

.

GDP at current prices

real GDPFor 2013 real GDP we use prices paid in

base year.

GDP at constant

prices

Price indexA number that represents all prices for a

given period of time –say a year-.

Nominal GDP

Real GDP

Price ApplePrice Apple

Price Computer

Price Computer

Price HaircutPrice Haircut

GDP

DeflatorGDP

Deflator ==

By how much to

multiply Real GDP to

get Nominal GDPBy how much to

multiply Real GDP to

get Nominal GDP

5

Nominal GDP = (30 apples x $0.2) + (100 computers x $800) + (300 haircuts x $10) + (50 cars x $15,000) + (60 houses x $450,000) + … = $17,120

Real GDP= (30 apples x $0.1) + (100 computers x $300) + (300 haircuts x $5) + (50 cars x $10,000) + (60 houses x $250,000) + … = $16,000

=Nominal GDP 17,120

Real GDP 16,000

GDP Deflator 1.07

GDP Deflator 1.07

Multiply Real

GDP times 1.07

to get Nominal GDP

Multiply Real

GDP times 1.07

to get Nominal GDP

The GDP Deflator

• A price index calculated from nominal and real GDP.

• Called “implicit” price deflator because it is the price implicit in the difference between real and nominal GDP.

The GDP Deflator Formula

GDP Deflator = Nominal GDPReal GDP X 100

Inflation Rate

8

Year GDP Deflator Inflation Rate2005 1132006 1162007 119

(Deflator Year X)

-(Deflator previous year)

(Deflator previous year)X 100

Which offer is better?

Colombia

$500,000 PesosBolivia

$650 Bolivianos

9

Rent is $250,000

Rent is $100

What is important is NOT how much they pay you, but how much you CAN BUY with what they pay you

Which offer is better?Colombia

$500,000 PesosBolivia

$650 Bolivianos

Rent is $250,000 Rent is

$100

Some things are more expensive, others are cheaper…

Food is $50,000

Food is $200

We need to put all prices into ONE single measure to be

able to see which salary buys more.

We need to put all prices into ONE single measure to be

able to see which salary buys more.

The Consumer Price Index

The CPI measures average change in prices over time for a basket of goods and services.

11

CPI

28,000 diaries and 60,000 interviews Determine

What and How Many?

28,000 diaries and 60,000 interviews Determine

What and How Many?

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A Basket of Basic Necessities

1. FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals and snacks);

2. HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture);

3. APPAREL (men's shirts and sweaters, women's dresses, jewelry);

4. TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance);

5. MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services);

6. RECREATION (televisions, cable television, pets and pet products, sports equipment, admissions);

7. EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);

8. OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

2007-2008

Although not a “price” CPI includes

Some government-charged user fees:• Water and sewerage charges, auto registration fees,

and vehicle tolls.

The CPI also includes taxes:• Such as sales and excise taxes that are directly

associated with the prices of specific goods and services.

CPI Excludes

Personal Taxes:• Such as income and Social Security taxes that are

not directly associated with purchase goods and services.

Prices of paper goods:• Such as stocks, bonds, real estate, and life insurance.

These are saving instruments not consumer goods.

What is included in each category?

Relative Importance

Calculating the CPI

16

Basket Quantity Price Base Year

Food 10 $10

Doctor 2 $50

Rent 1 $700

Gasoline 50 $2

Basket Cost   $1000

1982-841982-84

Item Quantity Price Base Year Price TodayFood 10 $10 $20Doctor 2 $50 $100Rent 1 $700 $1400Gasoline 50 $2 $4

Basket Cost   $1000 $2000

     

Basket is 2 times more expensive today than in the 

base year

CPI= (Basket Cost current year /      Basket Cost base year)*100

CPI= (Basket Cost current year /      Basket Cost base year)*100

CPI= 20

0

Item Quantity Price Base Year Price TodayFood 10 $10 $20Doctor 2 $50 $100Rent 1 $700 $1400Gasoline 50 $2 $4

Basket Cost   $1000 $2000CPI   (1000/1000)*100=100 (2000/1000)*100=200

Nominal Wage $1000 $1000

Real Wage ($1000/200)*100 = $500

Real Wage = Nominal Wage/Price Index)*100

$1,000 today buys half of what you could buy with $1,000 in the base year.

The real value of $

1000 today

’s dollars is

 

half ($500).

The real value of $

1000 today

’s dollars is

 

half ($500).

The real value tells

 you how much y

ou can 

REALLY buy

 with a given s

um of money.

The real value tells

 you how much y

ou can 

REALLY buy

 with a given s

um of money.

Which offer is better?

$500,000

Bolivia

$650 Bolivianos

$700

Colombia

$500,000 Pesos

The Core Consumer Price Index

20

The CPI Measures what consumers are paying for goods and services at malls, grocery stores and other retail locations. Unlike the overall CPI, the core CPI excludes food and energy prices, which can bounce around enough each month to distort the overall price trend picture.For the most recent core CPI data, click here.

Updating the Market Basket

• CPI revisions occur approximately every 10 years.

• The most important revision is the introduction of a new “market basket”

• The last revision to the CPI started in 1998 and completed in 2000.

21

Why is the CPI important?• Government use prices to set interest rates.• Used in labor contracts.• Landlords use it to determine rents.• Judges use it to determine alimony and child

support payments.• Used to adjust payments to:

• Social Security recipients (50 million)• Federal and Military retirees• Food Stamps and School Lunches (25 million)

• Used to adjust individual income tax brackets.

Cost Of Living Adjustment

Calculation is based on the increase in the CPI from the third quarter of the prior year to the third quarter of the current year.

24

CPI Inflation2004 1862005 192 3.232006 197.2 2.712007 205.8 4.362008 204.8 -0.492009 211.7 3.372010 215.889 1.98

Inflation Rate for Year X

(CPI Year X) - (CPI previous year)

(CPI previous year)X 100

Change in CPI relative to

previous year not to base year

26

Item Quantity Price Base

Year Price 2008 Price 2009Food 10 10 20 40Doctor 2 50 100 200Rent 1 700 1400 2800Gasoline 50 2 4 8Basket Cost   1000 2000 4000

     

Basket is 2 times more expensive in 2008  than in the base year

Basket is 4 times more expensive in 2009 than in the base year

CPI   100 200 400Inflation     (400-200)/200)*100=100%

You need 100% more money in 09 than in 08 to buy the same

basket.

Comparing dollar values across time

27

19301930 20112011

$100$100

CPI (1930) = 16.7CPI (1930) = 16.7 CPI (2011) = 226CPI (2011) = 226

(226)/(16.7)=13.5

(226)/(16.7)=13.5

Prices in 2011 are 13.5 times larger than in 1930Prices in 2011 are 13.5 times larger than in 1930

You need to have 13.5 times as much money in 2011You need to have 13.5 times as much money in 2011

Multiply by 13.5Multiply by 13.5 ??$1,350$1,350

Inflation• Refers to an INCREASE in the price

level from one period to the next.• Inflation can be high (20%) or low (2%)• When inflation drops (say from 20% to

2%) prices still INCREASE.

28

Deflation

• Refers to a DECREASE in the price level from one period to the next.

• Deflation results in a NEGATIVE inflation rate.

• Describes a DROP in prices.

30

Problems Measuring the Cost of Living

1. Substitution Bias: Because the basket is fixed, the CPI does not account for substitutions consumers do in response to higher prices.

32

33

4 Frozen Desserts3 Fruits

New

Ignores substitution away from “frozen” to “cake-like” desserts

Ignores substitution away from “frozen” to “cake-like” desserts

4 ice creams3 apples

Old

New Basket: More General Categories

Problems with CPI…

2. New Goods not included in the basket allow consumers to attain the same (or higher) standard of living at lower cost.

3. Unmeasured Quality change: If quality improves, a dollar buys more.

34

2.0 MB floppy to 256 Gb flash drive

Chained CPI• Utilizes expenditures in both the current and

base time periods in order to reflect the effect of any substitution that consumers may make across item categories in response to changes in relative prices.

• On average, the chained CPI is less than the conventional CPI by 0.25 to 0.3 percentage points.

• The Bureau of Labor Statistics has been tracking chained CPI since 2002.

GDP Deflator vs. CPIReflects prices of ALL

goods and services produced purchased by Consumers, Firms, Government, Other countries.

36

The GDP Deflator vs. CPI

GDP Deflator

Uses a basket with different goods and different quantities

Uses current production items and quantities.

CPI

Uses a basket with same goods and same quantities

Uses the Market Basket

37

Inflation Calculator

This site finds the equivalencies for dollars in different years.http://data.bls.gov/cgi-bin/cpicalc.pl

38

Measuring Prices• The Consumer Price Index (CPI) measures inflation as

experienced by consumers in their day-to-day living expenses• The Producer Price Index (PPI) measures inflation at earlier

stages of the production process• The Employment Cost Index (ECI) measures inflation in labor

costs• The BLS International Price Program measures price changes

for imports and exports• The Gross Domestic Product Deflator (GDP Deflator)

measures inflation experienced by both consumers themselves as well as governments and other institutions providing goods and services to consumers.

39

Employment Cost Index (ECI)Average Hourly Earnings (AHE)

ECI comes out quarterly and measures changes in employee wages, salaries and benefits. AHE, the Employment Situation report, comes out monthly, shows how worker wages are changing month to month. Both are important because rapidly rising labor costs can force businesses to raise prices to compensate, spurring inflation. For the most recent ECI data, click here. For the most recent AHE data, click here