ECONOMICSWhat Does It Mean To Me?

Unit 2: Unit 2: MEASURING THE MACROECONOMY

•Business Cycle

•Unemployment

•GDP Equation (nominal/real)

•Marginal Propensity to Consume/Save

•Price Deflator

•CPI

READ: Krugman Chapters 23, 24

OR Mankiw, Chapters 23, 24, 28

OR, here’s an idea!!

READ THEM ALL!!

Copyright © 2004 South-Western

*Mankiw

Websites for government agencies that collect economic data:

Bureau of Labor Statistics www.bls.gov

Federal Reserve www.federalreserve.gov

Congressional Budget Office www.cbo.gov

Department of Commerce www.commerce.gov

You have a handout for collecting economic data. It’s due tomorrow.

Ten Propositions about Which Most Economists Agree

Copyright © 2004 South-Western

*Mankiw

BUSINESS CYCLE

The Business Cycle is the short-run alternation between economic downturns and economic upturns.

Depression is a very deep and prolonged downturn. (over 3 reporting periods)

Recessions are periods of economic downturns when output and employment are falling. (2 reporting periods)

Expansions, sometimes called recoveries, are periods of economic upturns when output and employment are rising.

*Krugman

The Circular-Flow Diagram

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

Copyright © 2004 South-Western*Mankiw

An Expanded Circular-Flow Diagram: The Flows of Money Through the Economy

*Krugman

What happens during a business cycle, and what can be done about it?

the effects of recessions and expansions on unemployment;

the effects on aggregate output; and

the possible role of government policy.

QUESTIONS TO ANSWER:

Policy efforts undertaken to reduce the severity of recessions are called stabilization policy.

One type of stabilization policy is monetary policy, changes in the quantity of money or the interest rate. (raise/lower interest rate, raise/lower reserve requirement, buy/sell T-bills)

The second type of stabilization policy is fiscal policy, changes in tax policy or government spending, or both. (raise/lower taxes, raise/lower spending)

*Krugman

Secular long-run growth, or long-run growth, is the sustained upward trend in aggregate output per person over several decades.

A country can achieve a permanent increase in the standard of living of its citizens only through long-run growth. So a central concern of macroeconomics is what determines long-run growth.

*Krugman

UNEMPLOYMENT

*Mankiw

How Is Unemployment Measured?–Categories of Unemployment

•The problem of unemployment is usually divided into two categories, the long-run problem and the short-run problem.•Natural rate of unemployment does not go away on its own even in the long run.

•Cyclical rate of unemployment year-to-year fluctuations in unemployment around its natural rate.

*Mankiw

•Unemployment is measured by the Bureau of Labor Statistics (BLS).•It surveys 60,000 randomly selected households every month.•The survey is called the Current Population Survey

•Based on the answers to the survey questions, the BLS places each adult into one

of three categories:

**Employed

**Unemployed

**Not in the labor force

Employment is the number of people working in the economy.

Unemployment is the number of people who are actively looking for work but aren’t currently employed.

The labor force is equal to the sum of employment and unemployment.

*Krugman

*Mankiw

•Employed vs. unemployed–The BLS considers a person an adult if he or she is over 16 years old.–A person is considered employed if he or she has spent some of the previous week working at a paid job.–A person is unemployed if he or she is on temporary layoff, is looking for a job, or is waiting for the start date of a new job.–A person who fits neither of these categories, such as a full-time student, homemaker, or retiree, is not in the labor force.

*Mankiw

AdultPopulation

(223.4 million)

Labor Force(147.4 million)

Employed(139.3 million)

Not in labor force(76.0 million)

Unemployed (8.1 million)

Discouraged workers are non-working people who are capable of working but are not actively looking for a job. They would like to work but have given up looking for jobs after an unsuccessful search, don’t show up in unemployment statistics.

Underemployment is the number of people who work during a recession but receive lower wages than they would during an expansion due to smaller number of hours worked, lower-paying jobs, or both.

The unemployment rate is the ratio of the number of people unemployed to the total number of people in the labor force, either currently working

*Krugman

History of the unemployment rate since 1948

*Krugman

*Mankiw

• The unemployment rate is calculated as the percentage of the labor force that is unemployed.

Unemployment rate =Number unemployed

Labor force×100

*Mankiw

• The labor-force participation rate is the percentage of the adult population that is in the labor force.

Labor force

Adult population 100X

Labor Force Participation Rate

*Mankiw

10

8

6

4

2

01970 19751960 1965 1980 1985 1990 2005

Percent ofLabor Force

1995 2000

Natural rate ofunemployment

Unemployment rate

*Mankiw

Demographic Groups

*Mankiw

100

80

60

40

20

01950 1955 1960 1965 1970 1975 1980 1985 1990 2000

Labor-ForceParticipation

Rate (in percent)

Women

Men

1995 2005

1950

*Mankiw

*Mankiw

• In an ideal labor market, wages would adjust to balance the supply and demand for labor, ensuring that all workers

would be fully employed.

Why Are There Always Some People

Unemployed?

Quantity of labor

Wage Labor Supply

Labor Demand

WE

QE

*Mankiw

•Frictional unemployment refers to the unemployment that results from the time that it takes to match workers with jobs.

–In other words, it takes time for workers to search for the jobs that are best suit their tastes and skills.

•Structural unemployment is the unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one.

*Mankiw

•Unemployment insurance is a government program that partially protects workers’ incomes when they become unemployed.

*Mankiw

•Structural unemployment occurs when the quantity of labor supplied exceeds the quantity demanded. •Structural unemployment is often thought to explain longer spells of unemployment.•Why is there Structural Unemployment?

–Minimum-wage laws–Unions–Efficiency wages

•When the minimum wage is set above the level that balances supply and demand, it creates unemployment.

*Mankiw

Unemployment from a Wage Above the Equilibrium Level

Quantity ofLabor

0

Surplus of labor =Unemployment

Laborsupply

Labordemand

Wage

Minimumwage

LD LS

WE

LE

•A union is a worker association that bargains with employers over wages, benefits and working conditions. •In the 1940s and 1950s, when unions were at their peak, about a third of the U.S. labor force was unionized.•A union is a type of cartel attempting to exert its market power.•The process by which unions and firms agree on the terms of employment is called collective bargaining.

•A strike will be organized if the union and the firm cannot reach an agreement.

–A strike occurs when the union organizes a withdrawal of labor from the firm.

•A strike makes some workers better off and other workers worse off.•Workers in unions (insiders) reap the benefits of collective bargaining, while workers not in the union (outsiders) bear some of the costs.•By acting as a cartel with ability to strike or otherwise impose high costs on employers, unions usually achieve above-equilibrium wages for their members.•Union workers earn 10 to 20 percent more than nonunion workers.•Critics argue that unions cause the allocation of labor to be inefficient and inequitable.•Wages above the competitive level reduce the quantity of labor demanded and cause unemployment.•Some workers benefit at the expense of other workers.

•Efficiency wages are above-equilibrium wages paid by firms in order to increase worker productivity. •A firm may prefer higher than equilibrium wages for the following reasons:

–Worker health: Better paid workers eat a better diet and thus are more productive.–Worker turnover: A higher paid worker is less likely to look for another job.–Worker quality: Higher wages attract a better pool of workers to apply for jobs.–Worker effort: Higher wages motivate workers to put forward their best effort.

*Krugman

Unemployment Rate

GROSS DOMESTIC PRODUCT

GROSS DOMESTIC PRODUCTGROSS DOMESTIC PRODUCT is defined as:

The market value of all final goods and services produced within a country in a

given period of time. It does NOT include the value of intermediate goods.

Intermediate goods and services are inputs for production of final goods and services, such as the purchase of glass or steel to build an automobile

*Krugman

GDP can be calculated in one of 3 ways:

1) Measuring GDP as the Value of Production of Final Goods and Services.

2) Measuring GDP as Spending on Domestically Produced Final Goods and Services.

3) Measuring GDP as Factor Income Earned from Firms in the Economy.

Calculating GDP

*Krugman

2

3

13 ways to calculate

GDP

U.S. GDP in 2004: Two Methods of Calculating GDP

*Krugman

The four major components or determinants of Gross Domestic Product are:

•Consumption (C)

•Investment (I)

•Government Spending (G)

•Net Exports (X-M)

GDP (Y) is equal to:

C + I + G + (X - M)

Consumption 69%

Government Purchases

18% Net Exports -3 %

Investment16%

GDP and Its Components (2001)

The most important factor in aggregate demand is

CONSUMPTION (C)CONSUMPTION (C)

Therefore, understanding consumption is of vital importance, as it will eventually

affect total output and income.

Is it true that the higher the national income, the more it spends on consumer items?

The answer is YES.

However, it is also true that what matters most is not the total income but the after-tax income

called DISPOSABLE INCOMEDISPOSABLE INCOME.

Milton Friedman, economist, observed that consumption is related to permanent income rather than current income levels. This is called the PERMANENT INCOME PERMANENT INCOME HYPOTHESISHYPOTHESIS.

For example, it has been shown that college students and very old persons tend to spend more than their total income. These

groups DISSAVEDISSAVE.

On the other hand, people in their 30s and 40s tend to save quite a bit and consume relatively less of their income.

WHY IS THIS?

College students expect to make the bulk of their earnings after graduation and, thusly, base consumption on future earnings.

Middle age persons expect to retire in the future and tend to save for that eventuality.

Older people expect to die in the future and feel withdrawal of their savings is justified.

Additionally, the consumption rate Additionally, the consumption rate may be based on occupation.may be based on occupation.

Farmers have “good” years and “bad” years. They save more in

the good years to maintain consumption in the bad years.

A professional football player may save more and consume less during his playing years because he knows that his professional life is limited.

WHAT IS THE AVERAGE WHAT IS THE AVERAGE AND MARGINAL AND MARGINAL PROPENSITY TO PROPENSITY TO CONSUME?CONSUME?

Households will generally spend the majority of their total income and save the remainder.

The portion of total income consumed is called the AVERAGE PROPENSITY TO AVERAGE PROPENSITY TO

CONSUME (APC)CONSUME (APC).

(i.e.) If a family spends $1350 out of $1500 total income, it has an APC of 0.9

(1350/1500).

So, how would an increase in income affect the consumption of this family?

That depends on the MARGINAL MARGINAL PROPENSITY TO CONSUME (MPC)PROPENSITY TO CONSUME (MPC).

MPC is the additional consumption that results from an additional dollar of

disposable income.

If consumption goes from $1350 to $1800 while disposable income goes from $1500 to

$2100, what is the MPC?

Firstly, calculate change ( ) in consumption:

1800 - 1350 = 450

Secondly, calculate change ( ) in income:

2100 - 1500 = 600

MPC = consumption/disposable income

450/600 = 3/4 = 0.75

We interpret this by saying

…..for each additional for each additional dollar in after-tax dollar in after-tax

income, this family will income, this family will consume an additional consume an additional

0.75 or 75 cents0.75 or 75 cents.

Examples of changes in CONSUMPTION (C) might

include:

•Increase/decrease in consumer confidence or consumer expectations of the future. (i.e. raise in salary)

•Increase/decrease in wealth. (i.e. land, stocks, homes)

•Increase/decrease in taxes.

•Increase/decrease in population.

•Increase/decrease in savings or debt.

The next determinant in determining aggregate demand is:

INVESTMENT (I)INVESTMENT (I)Investment expenditures are an important

part of aggregate demand, as well as GDP; therefore, changes in investment spending will also be responsible for changes in the

level of economic activity.

If you will recall, spending on investments is the most unstable portion

of GDP because of its sensitivity to changes in political, social, and

economic conditions…..

First, we need to determine the difference between INDUCED INDUCED

INVESTMENTINVESTMENT and AUTONOMOUS AUTONOMOUS INVESTMENTINVESTMENT.

INDUCED INVESTMENT INDUCED INVESTMENT occurs when occurs when good good business climatebusiness climate “induces” firms to invest, as “induces” firms to invest, as

an increasing growth in future demand is likely.an increasing growth in future demand is likely.

The elements which impact Induced Investment include:

OPTIMISM: Investment is greater when people are more optimistic.

LEVEL OF AND RATE OF CHANGE in PROFITS: When economic growth is high,profits are high and rising. If total revenue is high, the resulting profit enables businesses to invest more.

AUTONOMOUS INVESTMENT AUTONOMOUS INVESTMENT is investment is investment that is not determined by the level of income.that is not determined by the level of income.

The elements which impact Autonomous Investment include:

INTEREST RATES: The higher the interest rate, the higher the opportunity cost in capital; fewer investments will now have benefits greater than the new higher costs.

RATE of CAPITAL UTILIZATION: When output is relative to the ability of business capital to produce goods, capital utilization rates are also low, and new investment will be lower.

INVENTORIES: High inventories occur when sales are less than expected.. Inventory investment will be high, causing a reduction in planned investment.

Examples of changes in INVESTMENT (I) might

include:

•Increase/decrease in interest rates.

•Increase/decrease in business confidence or expected returns on investment projects.

•Increase/decrease in business taxes.

•New and improved technology will stimulate investment.

•Degree in excess capacity (unused existing capital) will retard demand for new capital goods and reduce aggregate demand.

A third determinant of aggregate demand is:

GOVERNMENT SPENDING (G)

Government spending can vary over time for a variety of reasons. While volatile shifts may occur at the

beginning or end of wars, for example, the tendency is that spending will increase with rising income because of the decrease in welfare payments and

unemployment compensation.

An increase in GOVERNMENT SPENDING (G)

would also shift the aggregate demand curve to the right,

while a decrease in spending would shift the curve to

the left.

An example would be a decision by

government to expand the interstate highway system. In contrast, a reduction in spending, such as a cutback in orders for the military, will reduce aggregate

demand.

The fourth determinant of aggregate demand is:

NET EXPORTS (X - M)

The impact of international trade effects has become increasingly important. Exports (X) must be added to the demand side of the equation to realize the effect

of foreign buyers on our economy. Additionally, Import (M) must be subtracted from the equation to

realize purchases made which have no direct impact on our economy.

Exports minus imports (X - M) is what we call NET EXPORTSNET EXPORTS.

It represents BALANCE OF TRADE.It represents BALANCE OF TRADE.

A higher level of U.S. exports constitutes an increased foreign demand for U.S. goods.

A reduction of U.S. imports implies an increased domestic demand for U.S.-

produced products.

Positive net exports (X - M), as a result of greater demand for U.S. goods will create a

higher level of aggregate demand.

This might explain why a country in a This might explain why a country in a recession might like to run a trade recession might like to run a trade

surplus by increasing exports.surplus by increasing exports.

The non-price-level factors which alter net exports are primarily NATIONAL INCOME ABROAD and

EXCHANGE RATES.

NATIONAL INCOME ABROAD

Rising national income in a foreign nation increases the foreign demand for U.S. goods, increasing aggregate demand in the United

States.

Declines in national income abroad have the opposite effect: U.S. net exports decline, shifting the U.S. aggregate demand curve

leftward.

EXCHANGE RATESA change in the exchange rate between the dollar and other

currencies also affects net exports and hence aggregate demand.

Suppose the dollar price of yen rises, meaning the dollar depreciates in terms of the yen. This is the same as saying

the yen price of dollar falls--the yen appreciates.

The new relative values of dollars and yen means consumers in Japan can obtain more dollars with any particular number of

yen. Consumers in the U.S. can obtain fewer yen for each dollar.

Japanese consumers therefore discover that U.S. goods are cheaper in terms of yen……they buy more U.S. goods.

Consumers in the U.S. find that fewer Japanese products can be purchased with a set number of dollars…..they buy fewer

Japanese goods.

With respect the U.S. exports, a $30 pair of U.S.-made blue jeans now

might be brought for 2880 yen compared to 3600 yen. In terms of

U.S. imports, a Japanese watch might now cost $225 rather than $180.

Under these circumstances, U.S. exports will rise and imports will fall. This increase in NET This increase in NET EXPORTS translates into a rightward shift in EXPORTS translates into a rightward shift in

U.S. aggregate demand.U.S. aggregate demand.

A closed economy is an economy that does not trade goods, services, and assets.

The United States has become increasingly open, so that open-economy macroeconomics has become increasingly important.

Open-economy macroeconomics is the study of those aspects of macroeconomics that are affected by movements of goods, services, and assets across national boundaries.

*Krugman

One of the main concerns introduced by open-economy macroeconomics is the exchange rate, the price of one currency in terms of another.

Exchange rates can affect the aggregate price level.

They can also affect aggregate output through their effect on the trade balance, the difference between the value of the goods and services a country sells to other countries and the value of the goods and services it buys in return.

Economists are also concerned about capital flows, movements of financial assets across borders. *Krugman

Movements of the exchange rate between the U.S. dollar and the euro

*Krugman

•When major trading partners are experiencing economic slowdowns, causing the demand for exports to fall, shifting the curve to the left.

•When major trading partners are experiencing economic booms, causing the demand for exports to rise, shifting the curve to the right.

Examples of changes in NET EXPORTS (X - M) might include:

The Consumer Consumer Confidence SurveyConfidence Survey measures the level of confidence individual

households have in the performance of the

economy.

Questionnaires are sent to 5,000

households; about 3,500 are returned.

The five questions include:

•A rating of current business conditions in the household’s area.

•Rating of expected business conditions in six months.

•Current job availability in the area.

•Expected job availability in six months.

•Expected family income in six months.

The results are compiled into indexes for the present and expected future economic situations.

The Consumer Confidence index has the potential to reflect important aggregate

demand shifters.

•Will expected stock market wealth increase their spending?

•Will inflation on the horizon increase saving?

•Will expected joblessness decrease spending?

We can conclude, therefore, the PERCEPTIONS of consumers and

businesses on the state of the economy are important aggregate demand shifters

and can have a significant impact on price level, real output, and employment.

NOMINAL GDP vs.

REAL GDP

Real GDP: the value of the final goods and services produced calculated using the prices of some base year.

Nominal GDP: output valued at current prices.

Real GDP per capita is a measure of average output per person, but is not by itself an appropriate policy goal.

*Krugman

REAL VERSUS NOMINAL GDP

Nominal GDP

values the production of goods and services at current prices.

Real GDP

values the production of goods and services at constant prices.

*Krugman

*Krugman

Real vs. Nominal GDP

*Krugman

Real vs. Nominal GDP

*Krugman

The Relationship between Real GDP and Unemployment, 1949-2004

To calculate REAL GDP, we must choose a base year.

The current base year used for federal statistics is 2001.Therefore 2001 prices are used to calculate REAL GDP.

Because REAL GDP uses a constant base year, changes in REAL GDP measure only the amounts being produced.

In the year 2001, the economy produces 100 loaves of bread that sell for $2 each. In the year 2002, the economy produces 200 loaves of bread that sell for $3 each. Calculate nominal GDP, real GDP and the GDP price deflator for each year.

(use 2001 as the base year) by what percentage does each of these three statistics rise from one year to the next?

Year 2001 100 x $2 = 200 nominal GDP

100 x $2 = 200 real GDP

($200/$200) x 100 = 100 GDP deflator

Year 2002 200 x $3 = 600 nominal GDP

200 x $2 = $400 real GDP

($600/$400) x 100 = 150 GDP deflator

In the year 2001, the economy produces 100 loaves of bread that sell for $2 each. In the year 2002, the economy produces 200 loaves of bread

that sell for $3 each. Calculate nominal GDP, real GDP and the GDP price

deflator for each year. (use 2001 as the base year) By what percentage does each of these three statistics rise from

one year to the next?

Year 2001 100 x $2 = 200 nominal GDP

100 x $2 = 200 real GDP

($200/$200) x 100 = 100 GDP deflator

Year 2002 200 x $3 = 600 nominal GDP

200 x $2 = $400 real GDP

($600/$400) x 100 = 150 GDP deflator

Percentage change in nominal GDP is (600 - 200)/200 x 100 = 200%

Percentage change in real GDP is (400 - 200)/200 x 100 = 100%

Percentage change in the deflator is (150 - 100/100 x 100 = 50%

• You borrowed $1,000 for one year.

• Nominal interest rate was 15%.

• During the year inflation was 10%.

Real interest rate = Nominal interest rate – Inflation

= 15% - 10% = 5%

The GDP Price Deflator measures the current level of prices relative to the level of prices in the base year.

GDP DEFLATOR = X 100Nominal GDP

Real GDP

*Krugman

Calculating GDP and Real GDP in a Simple Economy

What is the total value of sales in the 1st year?

What is the total value of sales in the 2nd year?

(2000b x .25) + (1000b x .50) = $1000b

(2200b x .30) + (1200b x .70) = $1500b

Notice Notice the 2nd the 2nd year is year is 50% 50%

larger.larger.

Although the Although the quantities of both quantities of both

apples and oranges apples and oranges increased the prices increased the prices of both apples and of both apples and oranges also rose.oranges also rose.

So part of the 50% increase in So part of the 50% increase in the dollar value of GDP the dollar value of GDP

simply reflects higher prices, simply reflects higher prices, not higher production of not higher production of

output.output.

*Krugman

Calculating GDP and Real GDP in a Simple Economy

What is the total value of sales in the 1st year?

What is the total value of sales in the 2nd year?

(2000b x .25) + (1000b x .50) = $1000b

(2200b x .30) + (1200b x .70) = $1500b

So, how much would GDP have gone up if price had NOT changed?

To do this, simply calculate Q at year 1 prices.

.25) .50) $1150B

Now, we can define REAL GDP as the total value of final goods and

services produced in the economy during a year, calculated as if prices had stayed constant at the level of

some given base year.

*Krugman

U.S. real gross domestic product per person from 1900 to 2004

*Krugman

INFLATION and the INFLATION and the Consumer Price Index Consumer Price Index

(CPI)(CPI)

The aggregate price level is the overall level of prices in the economy.

A rising aggregate price level is inflation.

A falling aggregate price level is deflation.

The inflation rate is the annual percent change in the aggregate price level.

The economy has price stability when the aggregate price level is changing only slowly.

*Krugman

Inflation and deflation since 1929

*Krugman

Consumer price index from 1913 to 2004

*Krugman

CPI CPI -- prime indicator of inflation and recession

• Comprised of a market basket of goods and services.

• Measures current cost of living against base year (2000)

INFLATIONINFLATION: when the economy’s overall price level is rising.

INFLATION RATE: INFLATION RATE: percentage change in the price level from the previous period

*Krugman

Price Indexes and the Aggregate Price Level

A price index is the ratio of the current cost of that market basket to the cost in a base year, multiplied by 100.

Calculating the Cost of a Market Basket

Suppose a frost in Florida destroys most of the citrus crop. As a result, the price of oranges go from $.20 to $.40 and the price of grapefruit rises from

$.60 to $1.00 and lemons rise from $.25 to $.45.

We could recite three prices OR calculate an overall measure of the AVERAGE price increase.

Economists measure average price changes by comparing a consumer’s

consumption bundleconsumption bundle from year to year. This is also called the MARKET BASKETMARKET BASKET.

*Krugman

*Krugman

Calculating the Cost of a Market Basket

In the example above, the MARKET BASKET cost $95 before the frost.

After the frost, it cost $175.

Since 175/95 = 1.842, the post-frost basket costs 1.842 times the cost of the pre-frost basket, an increase of 84.2%.

In this case, we would say that the average price of citrus fruit increased 84.2% as a result of the frost.

*Krugman

The Makeup of the Consumer Price Index in 2004

FYI: What’s in the CPI’s Basket?FYI: What’s in the CPI’s Basket?

16%Food andbeverages

17%Transportation

Medical care

6%

Recreation

6%

Apparel

4%

Other goodsand services

4%

41%Housing

6%Education and communication

Copyright©2004 South-Western

*Krugman

The CPI, the PPI, and the GDP Deflator

Problems in Measuring the Cost of LivingProblems in Measuring the Cost of Living

Substitution bias*Consumers substitute toward goods that have become relatively less expensive.

*The index overstates the increase in cost of living by not considering consumer substitution

Introduction of new goods*New products result in greater variety, which in turn makes each dollar more valuable.

*Consumers need fewer dollars to maintain any given standard of living.

Unmeasured quality changes*If the quality of a good rises from one year to the next, the value of a dollar

rises, even if the price of the good stays the same.

*If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same.

*The BLS tries to adjust the price for constant quality, but such differences are hard to measure.

To calculate CPI:

1) Choose what goes into your market basket. The Bureau of Labor Statistics conducts surveys to determine the consumption of the typical consumer.

For example: 2 pizzas,3 sodas

When the CPI rises, a family will have to spend more money to make the same

purchases.

To calculate CPI:

2)Determine the prices of the market basket for each point in time.

Year PricePizza(2) PriceSoda(3)

2001 $5 $1

2002 $8 $2

2003 $10 $3

To calculate CPI:

3)Determine the total cost of the market basket.

Year PricePizza(2) PriceSoda(3)

2001 $5 $1

2002 $8 $2

2003 $10 $3

2001: (2x5) + (3x1) = $13

2002: (2x8) + (3x2) = $22

2003: (2x10) + (3x3) = $29

To calculate CPI:

4)Select a base year and compute the CPI in each year

2001: (2x5) + (3x1) = $13

2002: (2x8) + (3x2) = $22

2003: (2x10) + (3x3) = $29

2001: (13/13) x 100 = 100

2002: (22/13) x 100 = 169

2003: (29/13) x 100 = 223

To calculate CPI:

2002: (169-100)/100 x 100 = 69%

2003: (223-169)/169 x 100 = 32%

IR:yr2 = x 100

CPI:yr2 - CPI:yr1

CPI:yr1

5)Compute the Inflation Rate.

2001: (13/13) x 100 = 100

2002: (22/13) x 100 = 169

2003: (29/13) x 100 = 223

The CPI is used to calculate how prices have changed over

the years.

Let’s say you have $7 in your pocket to purchase some goods and services today. How much

money would you have needed in 1950 to buy the same amount of

goods and services?

The CPI for 1950 = 24.1

The CPI for 1999 (based on first 5 months of 1999 = 166.2

Use the following formula to compute the calculation:

1950 price = 1999 Price * (1950 CPI / 1999 CPI)

THE ANSWER:

$7.00 * 24.1 / 166.2 = $1.02

Let’s say your parents told you that in 1950 a movie cost

25 cents. How could you tell if movies have increased in price faster or slower than

most goods and services? To convert that price into today’s

dollars, use the CPI.

The CPI for 1950 = 24.1

The CPI for 1999 (based on first 5 months of 1999 = 166.2

Use the following formula to compute the calculation:

1999 price = 1950 Price * (1999 CPI / 1950 CPI)

THE ANSWER:

$0.25 * 166.2 / 24.1 = $1.72

In 1999, a full priced movie in South Florida cost

between $5.00 and $7.00. It looks like movies have

increased in price faster than most other goods and

services.

• Do the following to convert (inflate) Babe Ruth’s wages in 1931 to dollars in 2001:

Salary SalaryPrice level in 2001

Price level in 19312001 1931= ×

= ×

=

$80,.

$931,

000177152

579

Two Measures of InflationTwo Measures of Inflation

1965

Percentper Year

15

CPI

GDP deflator

10

5

01970 1975 1980 1985 1990 20001995

Copyright©2004 South-Western

QUESTIONS FOR REVIEW

Price Quantity Price Quantity

Year Hot Dogs Hot Dogs Hamburgers Hamburgers

2005 $1 100 $2 50

2006 $2 150 $3 100

2007 $3 200 $4 150

Two goods are produced: hot dogs and hamburgers:

What is the NOMINAL GDP for each year?

Nominal GDP for 2005 = ($1 x100) + ($2 x50) = $200

Nominal GDP for 2006 = ($2 x150) + ($3 x100) = $600

Nominal GDP for 2007 = ($3 x200) + ($4 x150) = $1,200

Price Quantity Price Quantity

Year Hot Dogs Hot Dogs Hamburgers Hamburgers

2005 $1 100 $2 50

2006 $2 150 $3 100

2007 $3 200 $4 150

Two goods are produced: hot dogs and hamburgers:

What is the REAL GDP for each year assuming a base year of 2005?

Real GDP for 2005 = ($1 x100) + ($2 x50) = $200

Real GDP for 2006 = ($1 x150) + ($2 x100) = $350

Real GDP for 2007 = ($1 x 200) + ($2 x150) = $500

Price Quantity Price Quantity

Year Footballs Footballs Basketballs Basketballs

Year 1 $10 120 $12 200

Year 2 $12 200 $15 300

Year 3 $14 180 $18 275

The country of Coltsville produces two goods: footballs and basketballs.

What is the nominal GDP for each year?

Nominal GDP for year 1 = ($10 x120) + ($12 x200) = $3,600

Nominal GDP for year 2 = ($12 x200) + ($15 x300) = $6,900

Nominal GDP for year 3 = ($14 x 180) + ($18 x275) = $7,470

Price Quantity Price Quantity

Year Footballs Footballs Basketballs Basketballs

Year 1 $10 120 $12 200

Year 2 $12 200 $15 300

Year 3 $14 180 $18 275

The country of Coltsville produces two goods: footballs and basketballs.

What is the real GDP for each year using year 1 as the base year?Real GDP for year 1 = ($10 x120) + ($12 x200) = $3,600

Real GDP for year 2 = ($10 x200) + ($12 x300) = $5,600

Real GDP for year 3 = ($10 x 180) + ($12 x275) = $5,100

NOTE that nominal GDP rises from Year 2 to Year 3, but real GDP falls.

Price Quantity Price Quantity

Year Footballs Footballs Basketballs Basketballs

Year 1 $10 120 $12 200

Year 2 $12 200 $15 300

Year 3 $14 180 $18 275

The country of Coltsville produces two goods: footballs and basketballs.

What is the GDP deflator for each year?

GDP deflator for year 1 = (3600/3600) x 100 = 1 x 100 = 100GDP deflator for year 2 = (6900/5600) x 100 = 1.2321 x 100 = 123.21

GDP deflator for year 3 = (7470/5100) x 100 = 1.4647 x 100 = 146.71

During 2009, the country of Meachotopia recorded a GDP of $65b, interest payments of $15b, imports of $13b, profits of $7b, exports

of $15b, and rent of $7b. This would mean wages during 2009 in Meachotopia were:

$36b

65b -15b -7b - 7b =

In the US, consumer spending accounts for what percentage of GDP?

70%

In the US, investment spending accounts for what percentage of GDP?

16%

GDP tends to understate our economic well being because it:

excludes the value of leisure

If real GDP rises while nominal GDP falls, then prices on average have

fallen

GDP tends to understate our economic well being because it:

excludes the value of leisure

If real GDP rises while nominal GDP falls, then prices on average have

fallen

Compiled by:Compiled by:Virginia H. Meachum, Economics TeacherVirginia H. Meachum, Economics Teacher

Coral Springs High SchoolCoral Springs High School

Sources:Sources:Principles, Problems, and Policies, by Campbell McConnell

& Stanley Brue

Exploring Economics, by Robert Sexton

Principles of Economics, by N. Gregory Mankiw

Economics, by Paul Krugman & Robin Wells

Notes by Florida Council on Economic Education and FAU Center for Economic Education

Notes by Foundation for Teaching Economics