Welcome To Welcome To MacroeconomicsMacroeconomics

Econ 2301Econ 2301

Dr. JacobsonDr. Jacobson

Mr. StuckeyMr. Stuckey

Chapter 7Chapter 7

Chapter 7Chapter 7

GDP and CPI:GDP and CPI:Tracking theTracking the

MacroeconomyMacroeconomy

In Chapter 7 We Look In Chapter 7 We Look at How Economists at How Economists

Use the GDP To Use the GDP To Measure the Quantity Measure the Quantity of Goods and Services of Goods and Services An Economy Produces.An Economy Produces.

In This Chapter We In This Chapter We Will Look At How Will Look At How

Economists Measure Economists Measure The Overall Cost of The Overall Cost of Living. This is Done Living. This is Done Through a Statistic Through a Statistic

Called the Consumer Called the Consumer Price Index (CPI).Price Index (CPI).

The Consumer Price The Consumer Price Index (CPI) is Used to Index (CPI) is Used to Monitor Changes in Monitor Changes in The Cost of Living The Cost of Living

Over Time.Over Time.

Remember When I Said the Remember When I Said the GDP Deflator Was One Way GDP Deflator Was One Way to Measure Inflation. This to Measure Inflation. This Occurred Because (If You Occurred Because (If You

Remember) Only Two Items Remember) Only Two Items Can Cause the GDP to Can Cause the GDP to

Increase: Prices or Increase: Prices or Production.Production.

In Looking at the GDP We In Looking at the GDP We Calculated Both The Calculated Both The

Nominal and Real GDP. Nominal and Real GDP. The Real GDP Eliminated The Real GDP Eliminated Price Increases and Gave Price Increases and Gave

Us An Increase (or Us An Increase (or Decrease) in Production Decrease) in Production

For the Period.For the Period.

From There We From There We Calculated The GDP Calculated The GDP

Deflator That Eliminated Deflator That Eliminated an Increase in Production an Increase in Production to Give Us an Increase in to Give Us an Increase in Prices For the Products Prices For the Products During This Period of During This Period of Time. This We Called Time. This We Called

This Increase the Rate of This Increase the Rate of Inflation.Inflation.

In Essence the In Essence the Consumer Price Index Consumer Price Index (CPI) is Just Another (CPI) is Just Another

Way of Computing the Way of Computing the Rate of Inflation.Rate of Inflation.

The Consumer Price The Consumer Price Index (CPI) Dates Back to Index (CPI) Dates Back to

1890 and is the Oldest 1890 and is the Oldest Continuous Statistical Continuous Statistical

Series Published By the Series Published By the Bureau of Labor Bureau of Labor

Statistics. It is Based on Statistics. It is Based on Approximately 3400 Approximately 3400 Commodity Prices.Commodity Prices.

Consumer Price Index Consumer Price Index (CPI)(CPI)

The Consumer Price The Consumer Price Index is a Measure of the Index is a Measure of the Overall Cost of the Goods Overall Cost of the Goods and Services Bought by a and Services Bought by a

Typical Consumer.Typical Consumer.

Consumer Price IndexConsumer Price Index

A Price Index That A Price Index That Measures The Cost of A Measures The Cost of A

Fixed Basket of Consumer Fixed Basket of Consumer Goods in Which the Weight Goods in Which the Weight

Assigned to Each Assigned to Each Commodity is the Share of Commodity is the Share of

Expenditures On That Expenditures On That Commodity By Urban Commodity By Urban

Consumers.Consumers.

The Consumer Price The Consumer Price Index (CPI) is Index (CPI) is

Calculated Monthly By Calculated Monthly By the Bureau of Labor the Bureau of Labor

Statistics (BLS) (Which Statistics (BLS) (Which is Part of the is Part of the

Department of Labor).Department of Labor).

Calculating the CPICalculating the CPI

1.1. Fix the Basket.Fix the Basket.

2.2. Find the Prices.Find the Prices.

3.3. Compute The Basket’s Cost.Compute The Basket’s Cost.

4.4. Choose a Base Year and Choose a Base Year and Compute the Index.Compute the Index.

5.5. Compute the Inflation Rate. Compute the Inflation Rate.

1.1. Fix The Basket.Fix The Basket.

Determine Which Prices Are Determine Which Prices Are Important to the Typical Important to the Typical

Consumer. This is Done By Consumer. This is Done By Surveying Consumers and Surveying Consumers and

Finding The Basket of Finding The Basket of Goods and Services, The Goods and Services, The Typical Consumer Buys.Typical Consumer Buys.

A 2001 Source Indicates A 2001 Source Indicates that The Standard Market that The Standard Market Basket Consisted of 365 Basket Consisted of 365

Separate Classes of Good Separate Classes of Good and Services That Were and Services That Were Collected From 23,000 Collected From 23,000 Establishments in 87 Establishments in 87 Areas of The Country.Areas of The Country.

2.2.Find The Prices.Find The Prices.

Find the Prices For Find the Prices For Each of the Goods Each of the Goods and Services In the and Services In the

Basket For Each Basket For Each Point in Time.Point in Time.

3.3. Compute the Basket’s Compute the Basket’s Cost.Cost.

Use the Data on Prices Use the Data on Prices to Calculate the Cost of to Calculate the Cost of

the Basket of Goods the Basket of Goods and Services At and Services At Different Times.Different Times.

4.4. Choose a Base Year and Choose a Base Year and Compute the Index.Compute the Index.

Designate One Year As the Designate One Year As the Base Year, Which is the Base Year, Which is the

Benchmark Against Which Benchmark Against Which Other Years Are Compared. Other Years Are Compared. Again, as With the GDP the Again, as With the GDP the

Earliest Year is Usually Earliest Year is Usually Designated as the Base Designated as the Base

Year.Year.

Once the Base Year is Once the Base Year is Chosen, the Index is Chosen, the Index is

Calculated as Follows:Calculated as Follows:

Price of BasketPrice of Basket of Goods and of Goods and Services ServicesConsumer = --------------------- X 100 Consumer = --------------------- X 100 Price Index Price of BasketPrice Index Price of Basket in Base Year in Base Year

5.5. Compute the Inflation Compute the Inflation Rate.Rate.

Using the Consumer Using the Consumer Price Index to Calculate Price Index to Calculate the Inflation Rate. The the Inflation Rate. The

Inflation Rate is the Inflation Rate is the Percentage Change in Percentage Change in

the Price Index From the the Price Index From the Preceding Period.Preceding Period.

The Inflation Rate Between The Inflation Rate Between Two Years is Calculated as Two Years is Calculated as

Follows:Follows:

CPI In CPI InCPI In CPI In

Inflation Rate in Year 2 – in Year 1Inflation Rate in Year 2 – in Year 1

In = X100In = X100

Year 2 CPI in Year 1Year 2 CPI in Year 1

Example: Example: Step 1: Survey Consumers Step 1: Survey Consumers

to Determine a Fixed to Determine a Fixed Basket of Goods.Basket of Goods.

Basket = 4 Hot Dogs, 2 Basket = 4 Hot Dogs, 2 HamburgersHamburgers

Step 2: Find the Price of Step 2: Find the Price of Each Good in Each Year.Each Good in Each Year.

Price of Price of Price of Price ofYear Hot Dogs Year Hot Dogs HamburgersHamburgers2005 $1 $22005 $1 $22006 2 32006 2 32007 3 42007 3 4

Step 3: Compute the Cost of Step 3: Compute the Cost of the Basket of Goods in Each the Basket of Goods in Each Year.Year.

2005 ($1/HD X 4HD) + ($2/HB 2005 ($1/HD X 4HD) + ($2/HB X 2 HB) = $8 Per BasketX 2 HB) = $8 Per Basket

2006 ($2/HD X 4HD) + ($3/HB 2006 ($2/HD X 4HD) + ($3/HB X 2 HB) = $14 Per BasketX 2 HB) = $14 Per Basket

2007 ($3/HD X 4HD) + ($4/HB2007 ($3/HD X 4HD) + ($4/HBX 2 HB) = $20 Per BasketX 2 HB) = $20 Per Basket

Step 4: Choose One Year Step 4: Choose One Year As a Base Year (2005) and As a Base Year (2005) and Compute the Consumer Compute the Consumer Price Index For Each Year.Price Index For Each Year.

2005* ($8/$8) X 100 = 1002005* ($8/$8) X 100 = 1002006 ($14/$8) X 100 = 2006 ($14/$8) X 100 = 1751752007 ($20/$8) X 100 = 2007 ($20/$8) X 100 = 250250* Note the Base Year By * Note the Base Year By Definition Will Always Be Definition Will Always Be 100100

Step 5: Use the Consumer Step 5: Use the Consumer Price Index to Compute the Price Index to Compute the Inflation Rate From Inflation Rate From Previous Year.Previous Year.

2006 (175 - 100)/ 100 X 100 = 2006 (175 - 100)/ 100 X 100 = 75%75%2007 (250 - 175)/ 175 X 100 = 2007 (250 - 175)/ 175 X 100 = 43%43%

2005/7 (250 - 100)/ 100 X 100 = 2005/7 (250 - 100)/ 100 X 100 = 150%150%

Other Indexes:Other Indexes:

Producer Price Index Producer Price Index (PPI)(PPI)

The Producer Price Index The Producer Price Index Measures the Cost of a Measures the Cost of a Basket of Goods and Basket of Goods and

Services Bought By Firms Services Bought By Firms Rather Than Consumers.Rather Than Consumers.

Other Indexes:Other Indexes:

The Bureau of Labor Statistics The Bureau of Labor Statistics Also Calculates the CPI for Also Calculates the CPI for Specific Metropolitan Areas Specific Metropolitan Areas

Such as Boston, New York and Such as Boston, New York and Los Angeles. In addition it Los Angeles. In addition it Calculates Some Narrow Calculates Some Narrow Categories Such As Food Categories Such As Food

Clothing, and Energy.Clothing, and Energy.

Problems With the CPIProblems With the CPI

1.1.Substitution Bias.Substitution Bias.

2.2. Introduction of New Goods.Introduction of New Goods.

3.3.Unmeasured Quality Unmeasured Quality Change.Change.

1.1. Substitution Bias:Substitution Bias:

When Prices Change When Prices Change From One Year to the From One Year to the Next, They Do Not all Next, They Do Not all

change Proportionately: change Proportionately: Some Prices Rise More Some Prices Rise More

Than Others. Consumers Than Others. Consumers Respond By Buying More Respond By Buying More or Less of the Product.or Less of the Product.

2.2. The Introduction of New The Introduction of New Goods.Goods.

When a New Good is When a New Good is Introduced, Consumers Introduced, Consumers Have More Variety From Have More Variety From Which to Choose, and This Which to Choose, and This in Turn Reduces the Cost of in Turn Reduces the Cost of Maintaining the Same Level Maintaining the Same Level of Economic Well-being.of Economic Well-being.

3.3. Unmeasured Quality Unmeasured Quality Change:Change:

If the Quality of a Good If the Quality of a Good Deteriorates From One Year Deteriorates From One Year to the Next, The Value of a to the Next, The Value of a Dollar Falls, Even if the Dollar Falls, Even if the Price of the Good Stay the Price of the Good Stay the Same, Because You Are Same, Because You Are Getting a Lesser Good For Getting a Lesser Good For The Same Amount of The Same Amount of Money.Money.

The Bureau of Labor The Bureau of Labor Statistics Has Statistics Has

Acknowledged Problems Acknowledged Problems in Their Calculations and in Their Calculations and

Have Made Some Have Made Some Adjustments to their Adjustments to their

Method of Calculations Method of Calculations Over the Years.Over the Years.

GDP Deflator Vs. The CPIGDP Deflator Vs. The CPI

1. 1. The First Difference is That the The First Difference is That the GDP Deflator Reflects the GDP Deflator Reflects the Prices of All Goods and Prices of All Goods and Services Produced Services Produced Domestically, Whereas the Domestically, Whereas the Consumer Price Index Reflects Consumer Price Index Reflects the Prices of All Goods and the Prices of All Goods and Services Bought by Consumers.Services Bought by Consumers.

2. The Next Difference is 2. The Next Difference is How Prices Are Weighted How Prices Are Weighted By the CPI. The CPI By the CPI. The CPI Compares the price of a Compares the price of a Fixed Basket of Goods and Fixed Basket of Goods and Services to the Price of the Services to the Price of the Basket in the Base Year. Basket in the Base Year. Only Occasionally does the Only Occasionally does the BLS Change the Basket of BLS Change the Basket of Goods.Goods.

2. Cont.2. Cont.

By Contrast, the GDP By Contrast, the GDP Deflator Compares the Deflator Compares the Price of Currently Price of Currently Produced Goods and Produced Goods and Services to the Price of Services to the Price of the Same Goods and the Same Goods and Services in the Base Services in the Base Year.Year.

Important Note:Important Note:

Therefore the Group of Therefore the Group of Goods and Services Used Goods and Services Used

to Compute the GDP to Compute the GDP Deflator Changes Deflator Changes

Automatically Over Time Automatically Over Time and the CPI Basket Does and the CPI Basket Does

Not.Not.

Comparing Dollar Figures Comparing Dollar Figures At Different Points in At Different Points in

Time.Time.

What Would an Item Cost What Would an Item Cost Today Verses That Same Today Verses That Same Item Purchased at Some Item Purchased at Some

Point in the Past?Point in the Past?

The Formula For Turning The Formula For Turning Dollar Figures From Year Dollar Figures From Year (T) Into Today’s Dollars is (T) Into Today’s Dollars is

As Follows:As Follows:

Price LevelPrice Level

Amount In Amount in TodayAmount In Amount in Today

Today’s Dollars = Year (T) Dollars X Today’s Dollars = Year (T) Dollars X

Price Level Price Level

In Year (T)In Year (T)

Babe Ruth’s SalaryBabe Ruth’s Salary

Babe Ruth’s Salary in 1931 Was $80,000.Babe Ruth’s Salary in 1931 Was $80,000.CPI For 1931 Was 15.2CPI For 1931 Was 15.2CPI For 2005 Was 195CPI For 2005 Was 195Using the Formula We Get:Using the Formula We Get: Salary in Salary In Price Level In Salary in Salary In Price Level In

200520052005 Dollars = 1931 Dollars X2005 Dollars = 1931 Dollars X Price Level in 1931Price Level in 1931

Babe Ruth’s SalaryBabe Ruth’s Salary

195195

Salary in 2005 Dollars = $80,000 XSalary in 2005 Dollars = $80,000 X

15.215.2

Salary in 2005 Dollars = $1,026,316Salary in 2005 Dollars = $1,026,316

IndexationIndexation

Price Indexes Are Used to Price Indexes Are Used to Correct For the Effects of Correct For the Effects of Inflation When comparing Inflation When comparing

Dollar Figures From Different Dollar Figures From Different Times. When Some Dollar Times. When Some Dollar Amount is Automatically Amount is Automatically

Corrected For Inflation By Law Corrected For Inflation By Law or Contract, the Amount is Said or Contract, the Amount is Said

to Be Indexed for Inflationto Be Indexed for Inflation

Indexation-Indexation-

Indexation is the Automatic Indexation is the Automatic Correction of a Dollar Correction of a Dollar

Amount for the Effects of Amount for the Effects of Inflation By Law or Inflation By Law or

Contract. Contract.

Examples: Cost-of-Living Examples: Cost-of-Living Allowance (COLA) Allowance (COLA)

Social SecuritySocial Security

Another Definition:Another Definition:

Indexing or IndexationIndexing or Indexationis a Mechanism By Which is a Mechanism By Which

Wages, Prices and Wages, Prices and Contracts Are Partially or Contracts Are Partially or

Wholly Adjusted for Wholly Adjusted for Changes in the General Changes in the General

Price Level. Price Level.

Real and Nominal Real and Nominal Interest RatesInterest Rates

Nominal Interest Rate- Is the Interest Rate as Usually Reported Without a Correction For the Effects of Inflation.

Real Interest Rate- Is the Interest Rate Corrected For the Effects of Inflation.

Calculation of Real Calculation of Real Interest RateInterest Rate

Real NominalReal Nominal

Interest = Interest - InflationInterest = Interest - Inflation

Rate Rate RateRate Rate Rate

QuestionsQuestions??

Quick WriteQuick Write

Do You Think That the Do You Think That the Consumer Price Index (CPI) Consumer Price Index (CPI) is a Good Measure of the is a Good Measure of the Goods and Services Bought Goods and Services Bought by Consumers? Why or Why by Consumers? Why or Why Not?Not?