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Welcome To
Macroeconomics
Econ 2301
Dr. Jacobson
Mr. Stuckey
Chapter 7
Chapter 7
GDP and CPI:
Tracking the
Macroeconomy
In Chapter 7 We Look
at How Economists Use
the GDP To Measure
the Quantity of Goods
and Services An
Economy Produces.
In This Chapter We Will
Look At How
Economists Measure
The Overall Cost of
Living. This is Done
Through a Statistic
Called the Consumer
Price Index (CPI).
The Consumer Price
Index (CPI) is Used to
Monitor Changes in The
Cost of Living Over
Time.
Remember When I Said the
GDP Deflator Was One Way
to Measure Inflation. This
Occurred Because (If You
Remember) Only Two Items
Can Cause the GDP to
Increase: Prices or
Production.
In Looking at the GDP We
Calculated Both The
Nominal and Real GDP.
The Real GDP Eliminated
Price Increases and Gave
Us An Increase (or
Decrease) in Production
For the Period.
From There We Calculated
The GDP Deflator That
Eliminated an Increase in
Production to Give Us an
Increase in Prices For the
Products During This
Period of Time. This We
Called This Increase the
Rate of Inflation.
In Essence the
Consumer Price Index
(CPI) is Just Another
Way of Computing the
Rate of Inflation.
The Consumer Price Index
(CPI) Dates Back to 1890
and is the Oldest
Continuous Statistical
Series Published By the
Bureau of Labor Statistics.
It is Based on
Approximately 3400
Commodity Prices.
Consumer Price Index
(CPI)
The Consumer Price Index
is a Measure of the Overall
Cost of the Goods and
Services Bought by a
Typical Consumer.
Consumer Price Index
A Price Index That Measures
The Cost of A Fixed Basket
of Consumer Goods in Which
the Weight Assigned to Each
Commodity is the Share of
Expenditures On That
Commodity By Urban
Consumers.
The Consumer Price
Index (CPI) is
Calculated Monthly By
the Bureau of Labor
Statistics (BLS) (Which
is Part of the
Department of Labor).
Calculating the CPI
1.
2.
3.
4.
Fix the Basket.
Find the Prices.
Compute The Basket’s Cost.
Choose a Base Year and
Compute the Index.
5. Compute the Inflation Rate.
1. Fix The Basket.
Determine Which Prices Are
Important to the Typical
Consumer. This is Done By
Surveying Consumers and
Finding The Basket of
Goods and Services, The
Typical Consumer Buys.
A 2001 Source Indicates
that The Standard Market
Basket Consisted of 365
Separate Classes of Good
and Services That Were
Collected From 23,000
Establishments in 87
Areas of The Country.
2. Find The Prices.
Find the Prices For
Each of the Goods
and Services In the
Basket For Each
Point in Time.
3. Compute the Basket’s
Cost.
Use the Data on Prices
to Calculate the Cost of
the Basket of Goods
and Services At
Different Times.
4. Choose a Base Year and
Compute the Index.
Designate One Year As the
Base Year, Which is the
Benchmark Against Which
Other Years Are Compared.
Again, as With the GDP the
Earliest Year is Usually
Designated as the Base
Year.
Once the Base Year is
Chosen, the Index is
Calculated as Follows:
Price of Basket
of Goods and
Services
Consumer = --------------------- X 100
Price Index
Price of Basket
in Base Year
5. Compute the Inflation
Rate.
Using the Consumer Price
Index to Calculate the
Inflation Rate. The
Inflation Rate is the
Percentage Change in the
Price Index From the
Preceding Period.
The Inflation Rate Between
Two Years is Calculated as
Follows:
Inflation Rate
In
Year 2
CPI In
CPI In
in Year 2 – in Year 1
=
X100
CPI in Year 1
Example:
Step 1: Survey Consumers
to Determine a Fixed Basket
of Goods.
Basket = 4 Hot Dogs, 2
Hamburgers
Step 2: Find the Price of
Each Good in Each Year.
Year
2005
2006
2007
Price of
Price of
Hot Dogs Hamburgers
$1
$2
2
3
3
4
Step 3: Compute the Cost of
the Basket of Goods in Each
Year.
2005 ($1/HD X 4HD) + ($2/HB X
2 HB) = $8 Per Basket
2006 ($2/HD X 4HD) + ($3/HB X
2 HB) = $14 Per Basket
2007 ($3/HD X 4HD) + ($4/HB
X 2 HB) = $20 Per Basket
Step 4: Choose One Year As
a Base Year (2005) and
Compute the Consumer Price
Index For Each Year.
2005* ($8/$8) X 100 = 100
2006 ($14/$8) X 100 = 175
2007 ($20/$8) X 100 = 250
* Note the Base Year By
Definition Will Always Be 100
Step 5: Use the Consumer
Price Index to Compute the
Inflation Rate From Previous
Year.
2006 (175 - 100)/ 100 X 100 = 75%
2007 (250 - 175)/ 175 X 100 = 43%
2005/7 (250 - 100)/ 100 X 100 =
150%
Other Indexes:
Producer Price Index (PPI)
The Producer Price Index
Measures the Cost of a
Basket of Goods and
Services Bought By Firms
Rather Than Consumers.
Other Indexes:
The Bureau of Labor Statistics
Also Calculates the CPI for
Specific Metropolitan Areas
Such as Boston, New York and
Los Angeles. In addition it
Calculates Some Narrow
Categories Such As Food
Clothing, and Energy.
Problems With the CPI
1.Substitution Bias.
2.Introduction of New Goods.
3.Unmeasured Quality
Change.
1. Substitution Bias:
When Prices Change From
One Year to the Next,
They Do Not all change
Proportionately: Some
Prices Rise More Than
Others. Consumers
Respond By Buying More
or Less of the Product.
2. The Introduction of New
Goods.
When a New Good is
Introduced, Consumers Have
More Variety From Which to
Choose, and This in Turn
Reduces the Cost of
Maintaining the Same Level
of Economic Well-being.
3. Unmeasured Quality Change:
If the Quality of a Good
Deteriorates From One Year
to the Next, The Value of a
Dollar Falls, Even if the Price
of the Good Stay the Same,
Because You Are Getting a
Lesser Good For The Same
Amount of Money.
The Bureau of Labor
Statistics Has
Acknowledged Problems
in Their Calculations and
Have Made Some
Adjustments to their
Method of Calculations
Over the Years.
GDP Deflator Vs. The CPI
1.
The First Difference is That 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.
2. The Next Difference is
How Prices Are Weighted By
the CPI. The CPI 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 of Goods.
2. Cont.
By Contrast, 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.
Important Note:
Therefore the Group of
Goods and Services Used
to Compute the GDP
Deflator Changes
Automatically Over Time
and the CPI Basket Does
Not.
Comparing Dollar Figures
At Different Points in
Time.
What Would an Item Cost
Today Verses That Same
Item Purchased at Some
Point in the Past?
The Formula For Turning
Dollar Figures From Year (T)
Into Today’s Dollars is As
Follows:
Price Level
Amount In
Amount in
Today
Today’s Dollars = Year (T) Dollars X
Price Level
In Year (T)
Babe Ruth’s Salary
Babe Ruth’s Salary in 1931 Was $80,000.
CPI For 1931 Was 15.2
CPI For 2005 Was 195
Using the Formula We Get:
Salary in
Salary In
2005
2005 Dollars = 1931 Dollars X
Price Level In
Price Level in 1931
Babe Ruth’s Salary
195
Salary in 2005 Dollars = $80,000 X
15.2
Salary in 2005 Dollars = $1,026,316
Indexation
Price Indexes Are Used to
Correct For the Effects of
Inflation When comparing
Dollar Figures From Different
Times. When Some Dollar
Amount is Automatically
Corrected For Inflation By Law
or Contract, the Amount is Said
to Be Indexed for Inflation
IndexationIndexation is the Automatic
Correction of a Dollar
Amount for the Effects of
Inflation By Law or Contract.
Examples: Cost-of-Living
Allowance (COLA)
Social Security
Another Definition:
Indexing or Indexation
is a Mechanism By Which
Wages, Prices and Contracts
Are Partially or Wholly
Adjusted for Changes in the
General Price Level.
Real and Nominal
Interest 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
Interest Rate
Real
Nominal
Interest = Interest Rate
Rate
Inflation
Rate
Questions
?
Quick Write
Do You Think That the
Consumer Price Index (CPI)
is a Good Measure of the
Goods and Services Bought
by Consumers? Why or Why
Not?