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Class 5, February 1, 2011

Measuring Aggregate Output and Prices How is GDP Defined? (Review)

How is it calculated: Flow of payments

Flow of income

Value added What does it measure?

Real versus Nominal GDP

What is left out?

Does it measure useful things?

Why do we care?

Computing The Cost of Living Consumer Price Index (CPI) How is the CPI Computed?

How is it Used?

Real v. Nominal Interest Rates

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the market value of all final goods &

services produced within a country

in a given period of time.

Gross Domestic Product (GDP) Is

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What Is Counted in GDP?

GDP includes all itemsproduced in the economy

and sold legally in markets.

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Why does the Government keep changing the

numbers? Preliminary v. revised.

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What Is Not Counted in GDP?

GDP excludes most items that are produced andconsumed at home and that never enter themarketplace.

It excludes items produced and sold illicitly, such asillegal drugs.

Because it is impossible to measure, some otherwiselegal activities that are hidden from tax authorities aremissed (underground economy).

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The Components of GDP Recall: GDP is total spending.

Four components:

Consumption (C)

Investment (I)

Government Purchases (G)

Net Exports (NX)

These components add up to GDP (denotedY):

Y = C + I + G + NX

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Consumption (C)

is total spending by households on g&s.

Note on housing costs:

For renters, consumption includes rent payments. For homeowners, consumption includes

the imputed rental value of the house,

but not the purchase price or mortgage payments.

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Investment (I)

is total spending on goods that will be used in the future to

produce more goods.

includes spending on

capital equipment (e.g., machines, tools) structures (factories, office buildings, houses)

inventories (goods produced but not yet sold)

Note: Investmentdoes not meanthe purchase of financial assets like

stocks and bonds.

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Which of the following is included in U.S.

GDP?

meals served by a restaurant located in

Canada but owned by an American citizen

the estimated rental value of owner-occupiedhousing

social security payments

unpaid household work

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Government Purchases (G)

is all spending on the g&s purchased orproduced by govtat the federal, state, and local levels.

G excludes transfer payments, such asSocial Security or unemployment insurancebenefits.

These payments represent transfers ofincome, not purchases of g&s.

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Net Exports (NX)

NX= exports imports

Exports represent foreign spending on the

economys g&s.

Imports are the portions ofC, I, and Gthat are spent on g&s produced abroad.

Adding up all the components of GDP gives:

Y = C + I + G + NX

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U.S. GDP and Its Components, 2005

2,444

7,950

7,07229,460

$42,035

per capita

5.8

18.9

16.870.1

100.0

% of GDP

726

2,360

2,1008,746

$12,480

billions

NX

G

I

C

Y

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Housing in GDP

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The Production Approach:

Value Added

Perhaps the most straightforward way of

measuring GDP

But must avoid double counting

value-added = value of production less value

of intermediate goods

At each stage of production add value-added

only to avoid double counting

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A simple example showing how value-

added avoids double counting

20_05

CaribouCoffee in

Minneapolis

Value addedby growingand pickingbeans

Value addedby roastingand packaging

Value of beans

Value addedby shippingand wholesaleservices

Value ofroasted andpackagedbeans

Value added byespressomachine and

service ata cafe

Value of shipped,roasted, and

packaged beanspurchased byCaribou Coffee

Value

ofa

cup

of

espresso

($1.5

0)

Coffeegrower

Coffeeroaster

Coffeeshipper andwholesaler

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Gross Domestic Product versus Net Domestic

Product

Depreciation

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Real versus Nominal GDP

Inflation can distort economic variables likeGDP, so we have two versions of GDP:

One is corrected for inflation, the other is not.

Nominal GDP values output using currentprices. It is not corrected for inflation.

Real GDP values output using the prices of

a base year. Real GDP is corrected forinflation.

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EXAMPLE:

Compute nominal GDP in each year:

Pizza Latte

year P Q P Q

2002 $10 400 $2.00 1000

2003 $11 500 $2.50 1100

2004 $12 600 $3.00 1200

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EXAMPLE:

Compute real GDP in each year,using 2002 as the base year:

Pizza Latte

year P Q P Q

2002 $10 400 $2.00 1000

2003 $11 500 $2.50 1100

2004 $12 600 $3.00 1200

$10 $2.00

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The GDP Deflator

The GDP deflator is a measure of the overall level

of prices.

Definition:

One way to measure the economys inflation rate is

to compute the percentage increase in the GDP

deflator from one year to the next.

GDP deflator = 100 x nominal GDPreal GDP

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EXAMPLE:

In each year,

nominal GDP is measured using the (then) currentprices.

real GDP is measured using constant prices from thebase year (2002 in this example).

year

Nominal

GDP

Real

GDP2002 $6000 $6000

2003 $8250 $7200

2004 $10,800 $8400

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Nominal and Real GDP (Base 2005)

0.0

2,000.0

4,000.0

6,000.0

8,000.0

10,000.0

12,000.0

14,000.0

16,000.0

1950 1960 1970 1980 1990 2000 2010 2020

Nominal GDP

Real GDP

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GDP and Economic Well-Being Real GDP per capita is the main indicator of

the average persons standard of living.

But GDP is not a perfect measure of

well-being.

Robert Kennedy issued a very eloquent

yet harsh criticism of GDP:

G i d

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Gross Domestic Product does not allow for the health of ourchildren, the quality of their education,

or the joy of their play.It does notinclude the beauty of our poetry or

the strength of our marriages, the

intelligence of our public debate or

the integrity of our public officials.

It measures neither our courage, nor our wisdom,

nor our devotion to our country. It measures everything,

in short, except that which makes life worthwhile, and it

can tell us everything about America except why we are

proud that we are Americans.

-Senator Robert Kennedy, 1968

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Then Why Do We Care About GDP?

Having a large GDP enables a country to afford

better schools, a cleaner environment,health care, etc.

Many indicators of the quality of life are

positively correlated with GDP. For example

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GDP and Adult Literacy in 12 Countries

30

40

50

60

70

80

90

100

$0 $10,000 $20,000 $30,000 $40,000

Adult Literacy

(% ofpopulation)

Real GDP per capita, 2002

U.S.Germany

Japan

Russia

Nigeria

Mexico

Brazil

China

Pakistan

Bangladesh

India

Indonesia

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GDP and Internet Usage in 12 Countries

0

10

20

30

40

50

60

$0 $10,000 $20,000 $30,000 $40,000

Internet

Usage(% of

population)

Real GDP per capita, 2002

U.S.

Germany

Japan

Mexico

RussiaBrazil

China

T bl 3 GDP Lif E d Li

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Table 3 GDP, Life Expectancy, and Literacy

Copyright2004 South-Western

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GDP Does Not Value:

the quality of the environment

leisure time

non-market activity, such as the child carea parent provides his or her child at home

an equitable distribution of income

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The Consumer Price Index (CPI)

Measures the typical consumers cost of living.

The basis of cost of living adjustments (COLAs)

in many contracts and in Social Security.

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How the CPI Is Calculated

1. Fix the basket.The Bureau of Labor Statistics (BLS) surveysconsumers to determine whats in the typicalconsumers shopping basket.

2. Find the prices.

The BLS collects data on the prices of all the goodsin the basket.

3. Compute the baskets cost.

Use the prices to compute the total cost of thebasket.

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How the CPI Is Calculated

4. Choose a base year and compute the index.The CPI in any year equals

5. Compute the inflation rate.

The percentage change in the CPI from the

preceding period.

100 xcost of basket in current year

cost of basket in base year

CPI this year CPI last year

CPI last year

inflation

ratex 100%=

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EXAMPLE basket: {4 pizzas, 10 lattes}

$12 x 4 + $3 x 10 = $78

$11 x 4 + $2.5 x 10 = $69

$10 x 4 + $2 x 10 = $60

cost of basket

$3.00

$2.50

$2.00

price of

latte

$122005

$112004

$102003

price of

pizzayear

Compute CPI in each year:

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EXAMPLE basket: {4 pizzas, 10 lattes}

$12 x 4 + $3 x 10 = $78

$11 x 4 + $2.5 x 10 = $69

$10 x 4 + $2 x 10 = $60

cost of basket

$3.00

$2.50

$2.00

price of

latte

$122005

$112004

$102003

price of

pizzayear

Compute CPI in each year:

2003: 100 x ($60/$60) = 100

2004: 100 x ($69/$60) = 115

2005: 100 x ($78/$60) = 130

15%

13%

Inflation rate:

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A C T I V E L E A R N I N G 1:

Calculate the CPI

41

The basket contains

20 movie tickets

and 10 textbooks.

The table shows their prices

for 2004-2006.

The base year is 2004.

A. How much did the basket cost in 2004?

B. What is the CPI in 2005?

C. What is the inflation rate from 2005-2006?

movie

tickets

text-

books

2004 $10 $50

2005 $10 $60

2006 $12 $60

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Whats in the CPIs Basket?

42%

17%

15%

6%

6%

6%

4%4% Housing

Transportation

Food & Beverages

Medical care

Recreation

Education and

communicationApparel

Other

P bl With th CPI

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Problems With the CPI:

Substitution Bias

Over time, some prices rise faster than others.

Consumers substitute toward goods that

become relatively cheaper. The CPI misses this substitution because it

uses a fixed basket of goods.

Thus, the CPI overstates increases in the costof living.

P bl With th CPI

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Problems With the CPI:

Introduction of New Goods When new goods become available,

variety increases,

allowing consumers to find productsthat more closely meet their needs.

This has the effect of making each dollarmore valuable.

The CPI misses this effect because it uses a

fixed basket of goods.

Thus, the CPI overstates increases in the costof living.

P bl With th CPI

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Problems With the CPI:

Unmeasured Quality Change

Improvements in the quality of goods in the basket

increase the value of each dollar.

The BLS tries to account for quality changes,

but probably misses some quality improvements, as

quality is hard to measure.

Thus, the CPI overstates increases in the cost of

living.

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Problems With the CPI

Each of these problems causes the CPI to

overstate cost of living increases.

The BLS has made technical adjustments,

but the CPI probably still overstates inflation

by about 0.5 percent per year.

This is important, because Social Security

payments and many contracts have COLAstied to the CPI.

T M f I fl i

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Two Measures of Inflation

-5

0

5

10

15

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Percent

per Year

CPI GDP deflator

C i h CPI d GDP D fl

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Imported consumer goods: included in CPI excluded from GDP deflator

The basket: CPI uses fixed basket

GDP deflator uses basket of

currently produced goods & services

This matters if different prices are

changing by different amounts.

Capital goods: excluded from CPI

included in GDP deflator (if produced

domestically)

Contrasting the CPI and GDP Deflator

Correcting Variables for Inflation:

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Correcting Variables for Inflation:

Comparing Dollar Figures from Different Times

Inflation makes it harder to compare dollar

amounts from different times.

We can use the CPI to adjust figures so thatthey can be compared.

A C T I V E L E A R N I N G 3

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A C T I V E L E A R N I N G 3:

Exercise-Hypothetical data

1980: CPI = 90,avg starting salary for econ majors = $24,000

Today: CPI = 180,avg starting salary for econ majors = $50,000

Are econ majors better off today or in 1980?

50

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Real data: In 2005 the average starting salary

of an Emory econ major place through the

career center was: $56, 890.

h Hi h i f G li

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EXAMPLE: The High Price of Gasoline

Price of a gallon of regular unleaded gas:

$1.42 in March 1981

$2.50 in August 2005

To compare these figures, we will use the CPI to express the

1981 gas price in 2005 dollars,what gas in 1981 would have cost if the

cost of living were the same then as in 2005.

Multiply the 1981 gas price by

the ratio of the CPI in 2005 to the CPI in 1981.

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0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

1919 1929 1939 1949 1959 1969 1979 1989 1999 2009

Annual Motor Gasoline Retail PriceDollars per gallon

Nominal Price

Forecast

EIA Short-Term Energy Outlook, January 2011

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