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TODAY
Simple problems illustrating the
computation of GDP and real GDP
Define price indexes
Inflation
Use price index to compute real
quantities (out of nominal data)
Some simple review problems (1)
If a pizza maker pays $1 for tomatoes,
$1 for cheese, $2 for sausage, and sells
the pizza made with these ingredients
for $7, then each pizza sold contributes
how much to GDP?
–
–
–
–
$3
$4
$7
$9
Simple review problems (2)
Year
1982
1992
2002
Prices
100
150
300
Nominal GDP
$1,600
$3,000
$6,000
In the above table, which of the following is
true concerning changes between 1992 and
2002?
– A) Nominal and real GDP both increased.
– B) Nominal GDP increased, but real GDP was
unchanged.
– C) Nominal GDP increased, but real GDP
decreased.
– D) None of the above statements are true
Simple review problems (3)
The above table reports data for
book-and-pen-country during 2004
and 2005
What was the real GDP of book-andpen country during 2004 (if the base
year is 2005)?
Measuring the price
level and inflation
Price indexes
• It is useful to have a single number that
summarizes the overall price level of the
economy
• Price indexes help us obtaining real
quantities out of nominal ones
• For any period, a price index measures the
cost of a basket of goods relative to the
cost of the same basket in a fixed year
(called base year)
How to compute a price index
• Determine the base year
• Determine the “representative basket”
(consumption goods, production goods, all goods in
GDP, etc)
• To construct the price index in year t, multiply prices
of period t by the quantities in the representative
basket. Finally, divide by the cost of the rep. basket
during the base year
Price index, Example 1
Basket is:
Rent, pizza rustica,
entertainment
Base year 2003
Rent (1): $2000
Pizza (10): $ 100
Entert. (5):$ 900
Cost = $ 3000
Year 2004
Rent (1): $2,200
Pizza (10): $ 110
Entert. (5): $ 990
Cost =
$3,300
Price index2004(2003=1)=
$3,300/$3,000 =1.1
Price index, Example 2
Compute price index for 2005
(base 2004).
What is inflation? how do
we measure it?
• Inflation is the sustained increase in the overall
price level of the economy (if the price level goes
down, then we say there is deflation)
• We measure inflation (deflation) by the percentage
increase (decrease) in the corresponding price
index
• The standard price index used to compute inflation
is the CPI (consumer’s price index)
Measuring inflation, Ex. 1
• According to the BEA, the CPI
during 2006 (Q2) = 1.1459. The CPI
during 2006 (Q1) = 1.1344.
• What was the inflation rate from the
first to the second quarter of 2006?
Computing real quantities
out of nominal quantities
• An important use of price indexes is to adjust
nominal quantities for the effects of inflation
• Using price indexes we can deflate a
nominal quantity and transform it into a real
quantity, which is measured in physical
terms (goods and services) – real quantities
are what economists care about
Computing real quantities
(contd)
• How?
Dividing a nominal quantity by an appropriate
price index obtains a real quantity (with base
equal to that of the price index)
Using a price index
(Example 1)
• Suppose you invested $100 in the
stock market on 1986
• Stock market index has increased
by a factor of 6
• Does this mean I can buy 6 times
more goods and services than what
I sacrificed in 1986?
Example 1: contd
Example 1 (contd)
• From Yahoo, the S&P 500
– Index (1986) = 200
– Index (2004) = 1163
• The BLS reports the consumer price
index
– CPI (1986) = 109.6
– CPI (2004) = 188.9
Real stock mkt 1986 =1.8248
Real stock mkt 2004 =6.1566
Real return is roughly 3-fold (6.15/1.82)
(as opposed to 6-fold in nominal terms)