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Chapter 5
Macroeconomics the Big
Picture
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Gross Domestic Product
 In simple terms, GDP is the total output
produced in an economy
 It is often used to measure:
USA: 14.59 trillion
 The size of an economy
Japan: 4.91 trillion
 The performance of an economy
GDP shrunk
USStandard
of
by 4% in the 3rd
quarter of 2009
Germany: 3.65 trillion
US
GDP
grew
by
living in an economy
2% in the 1st
quarter of 2010
Commonly measured by
per capital GDP
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2008 GDPs
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Gross Domestic Product
 Formal definition:
 Nominal GDP
value of
andand
services
finalgoods
Total value
of all
allfinal
final
goods
services
produced in an
an economy
economy in given
given year
yearvalued
valued
at the current
current
price
current price
price
 Real GDP
Total value of all final goods and services
produced in an economy in given year
adjusted
adjusted to
to eliminate
eliminate the
the effect
effect of
of price
price
change
change
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Nominal and Real GDP
 Consider the following table
Goods and
Services
2008
2009
P
Q
Text Book
100
500
Hair Cuts
10
400
P
Q
Nominal GDP in 2008
100 X 500
+
10 X 400
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=
54,000
5
Nominal and Real GDP
Goods and
Services
2008
2009
P
Q
P
Q
Text Book
100
500
150
400
Hair Cuts
10
400
15
300
Nominal GDP in 2008
100 X 500
+
10 X 400
=
54,000
=
64,500
Nominal GDP in 2009
150 X 400
+
15 X 300
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Nominal and Real GDP
Goods
and
Services
Text Book
Hair Cuts
2008
2009
P
Q
P
Q
1985
P
100
10
500
400
150
15
400
300
75
5
Real GDP in 2008
75 X 500
+
5 X 400
=
39,500
=
31,500
Real GDP in 2009
75 X 400
+
5 X 300
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Business Cycle
 Economy does not grow at a constant rate
 Rather, it has a cyclical pattern, which can be
described by following components:
 Expansion
 Recession
 Peak
 Trough
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Business Cycle
 An expansion is a sustained period in which
real GDP is rising.
 A recession is a sustained period in which real
GDP is falling.
 A peak is the point of the business cycle at
which an expansion ends and a recession
begins.
 A trough is the point of the business cycle at
which a recession ends and an expansion
begins.
Business Cycle
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U.S. Real GDP
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Changes in Price Level
 Price Levels are different from Price we
learned in chapter 3
 It is NOT the price of apple, orange or
banana
 It is the average price of all goods and
services in an economy
 Usually, measured by a basket of
representative goods and services
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Changes in Price Level
 For example CPI or Consumer Price Index
tracks the prices of goods and services
purchased by a typical urban family of four.
 When price level rises, we call this Inflation
 When price level falls, we call this deflation
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Inflation in the U.S.
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Impacts of Inflation
 Unanticipated inflation has following
adverse impacts:
 Fall of purchasing power
 Redistributes wealth
 Creates uncertainty
 Hurts lenders and benefits borrowers
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Impacts of deflation
 Unanticipated deflation has following
adverse impacts:
 Redistributes wealth
 Creates uncertainty
 Hurts borrowers and benefits lenders
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Computation of CPI
 Price Index is a number whose movement
reflects the changes in average price level
 In any index system, we select a base period
and compare the changes in price levels from
the base period
 Typically, indexing is done in such a way
that,
Price Index for the Base Period= 100
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Computation of CPI
 Lets assume that Base period is 1985. So,
CPI1985 = 100
 Now, if I tell you that CPI2000 = 150
 What can we say about price level in 2000?





Clearly, price level has increased from 1985
Therefore, economy observed inflation
By how much?
It is 50% compared to the base year
This is the advantage of indexing to 100
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Another Example
 Lets assume again, CPI1985 = 100
 Now, if I tell you that CPI2005 = 160
 What can we say about price level in 2005?





Again, price level has increased from 1985
Therefore, economy observed inflation
By how much?
It is 60% compared to the base year
Can we say anything about inflation compared
to 2000 (CPI2000=150)?
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Another Example
 To compute inflation compared to non-base
years, we need some simple computations
 Note we have,
CPI1985 = 100 CPI2000 = 150 CPI2005 = 160
 We like to know how price level had changed
form 2000 to 2005
 Again looks like its an inflation. But how much?
 We want to know, 150 to 160 is an increase of
how many percentage points?
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Percentage Computation
 All percentage computations, use the same
formula:
NEW
OLD
X
100
OLD
 So, computing percentage change in CPI from
2000 (150) to 2005 (165)
160 – 150
X 100 = 6.67%
150
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In class Exercise
 Assume,
CPI1985 = 100 CPI1975 = 88 CPI2002 = 138
 Compute the inflation rate in 1975 compared to
the base year
 Compute the inflation rate in 2002 compared to
the base year
 Compute the inflation rate in 2002 compared to
1975
 Note inflation rate means percentage change in
CPI
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Construction of CPI
 BLS surveys, computes and publishes CPI
Price Data
Goods and Services
Market Basket
2000
Price
1985
Price
 Apple
10 pounds
$4.00
$2.00
 Banana
15 pounds
$1.00
$0.50
$3.00
$0.25
 Cat food
2 bags
 To compute CPI, we first compute the Cost of
basket (COB)
 Here, COB2000 =10x4 + 15x1 + 2x3 = 61
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Construction of CPI
Price Data
Goods and Services
Market Basket
2000
Price
1985
Price
 Apple
10 pounds
$4.00
$2.00
 Banana
15 pounds
$1.00
$0.50
$3.00
$0.25
 Cat food
2 bags
 Here, COB2000 =10x4 + 15x1 + 2x3 = 61
 Here, COB1985 =10x2 + 15x.50 + 2x.25 = 28
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Formula for CPI
 Use COB numbers to the formula for CPI
CPI xxxx =
COBxxxx
X 100
COBBaseYear
 Using this formula compute
 CPI of 1985 (the base year)
 CPI of 2000
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