NOMINAL GDP For 2013 GDP we use prices paid in GDP at current prices

REAL GDP For 2013 real GDP we use prices paid in base year. GDP at constant prices

PRICE INDEX A number that represents all prices for a given period of time –say a year-.

Nominal GDP Real GDP Price Apple Price Computer Price Haircut GDP Deflator = = By how much to multiply Real GDP to get Nominal GDP

5 Nominal GDP = (30 apples x $0.2) + (100 computers x $800) + (300 haircuts x $10) + (50 cars x $15,000) + (60 houses x $450,000) + … = $17,120 Real GDP= (30 apples x $0.1) + (100 computers x $300) + (300 haircuts x $5) + (50 cars x $10,000) + (60 houses x $250,000) + … = $16,000 = Nominal GDP 17,120 Real GDP 16,000 GDP Deflator 1.07 Multiply Real GDP times 1.07 to get Nominal GDP

The GDP Deflator A price index calculated from nominal and real GDP. Called “implicit” price deflator because it is the price implicit in the difference between real and nominal GDP.

The GDP Deflator Formula GDP Deflator = Nominal GDP Real GDP X 100

Inflation Rate 8 (Deflator Year X) - (Deflator previous year) X 100

Which offer is better? Colombia $500,000 Pesos Bolivia $650 Bolivianos 9 Rent is $250,000 Rent is $100 What is important is NOT how much they pay you, but how much you CAN BUY with what they pay you

Which offer is better? Colombia $500,000 Pesos Bolivia $650 Bolivianos Rent is $250,000 Rent is $100 Some things are more expensive, others are cheaper… Food is $50,000 Food is $200 We need to put all prices into ONE single measure to be able to see which salary buys more.

The Consumer Price Index The CPI measures average change in prices over time for a basket of goods and services. 11 CPI

28,000 diaries and 60,000 interviews Determine What and How Many? 28,000 diaries and 60,000 interviews Determine What and How Many? 200 categories of goods and services divided into 8 groups and weighted by importance. A Basket of Basic Necessities 1. FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals and snacks); 2. HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture); 3. APPAREL (men's shirts and sweaters, women's dresses, jewelry); 4. TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance); 5. MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services); 6. RECREATION (televisions, cable television, pets and pet products, sports equipment, admissions); 7. EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories); 8. OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses)

Although not a “price” CPI includes Some government-charged user fees: Water and sewerage charges, auto registration fees, and vehicle tolls. The CPI also includes taxes: Such as sales and excise taxes that are directly associated with the prices of specific goods and services.

CPI Excludes Personal Taxes: Such as income and Social Security taxes that are not directly associated with purchase goods and services. Prices of paper goods: Such as stocks, bonds, real estate, and life insurance. These are saving instruments not consumer goods.

What is included in each category? Relative Importance

Calculating the CPI 16 BasketQuantityPrice Base Year Food10$10 Doctor2$50 Rent1$700 Gasoline50$2 Basket Cost $

ItemQuantityPrice Base YearPrice Today Food10$10$20 Doctor2$50$100 Rent1$700$1400 Gasoline50$2$4 Basket Cost $1000$2000 Basket is 2 times more expensive today than in the base year CPI= (Basket Cost current year / Basket Cost base year)*100 CPI= 200

ItemQuantityPrice Base YearPrice Today Food10$10$20 Doctor2$50$100 Rent1$700$1400 Gasoline50$2$4 Basket Cost $1000$2000 CPI (1000/1000)*100= 100 (2000/1000)*100= 200 Nominal Wage$1000 Real Wage ($1000/200)*100 = $500 Real Wage = Nominal Wage/Price Index)*100 $1,000 today buys half of what you could buy with $1,000 in the base year. The real value of $1000 today’s dollars is half ($500). The real value tells you how much you can REALLY buy with a given sum of money.

Which offer is better? $500,000 Bolivia $650 Bolivianos $700 Colombia $500,000 Pesos

The Core Consumer Price Index 20 The CPI Measures what consumers are paying for goods and services at malls, grocery stores and other retail locations. Unlike the overall CPI, the core CPI excludes food and energy prices, which can bounce around enough each month to distort the overall price trend picture. For the most recent core CPI data, click here.here

Updating the Market Basket CPI revisions occur approximately every 10 years. The most important revision is the introduction of a new “market basket” The last revision to the CPI started in 1998 and completed in

Why is the CPI important? Government use prices to set interest rates. Used in labor contracts. Landlords use it to determine rents. Judges use it to determine alimony and child support payments. Used to adjust payments to: Social Security recipients (50 million) Federal and Military retirees Food Stamps and School Lunches (25 million ) Used to adjust individual income tax brackets.

Cost Of Living Adjustment Calculation is based on the increase in the CPI from the third quarter of the prior year to the third quarter of the current year.

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Inflation Rate for Year X (CPI Year X) -(CPI previous year) X 100 Change in CPI relative to previous year not to base year

26 ItemQuantity Price Base YearPrice 2008Price 2009 Food Doctor Rent Gasoline50248 Basket Cost Basket is 2 times more expensive in 2008 than in the base year Basket is 4 times more expensive in 2009 than in the base year CPI Inflation ( )/200)*100=100% You need 100% more money in 09 than in 08 to buy the same basket.

Comparing dollar values across time $100 CPI (1930) = 16.7 CPI (2011) = 226 (226)/(16.7) =13.5 (226)/(16.7) =13.5 Prices in 2011 are 13.5 times larger than in 1930 You need to have 13.5 times as much money in 2011 Multiply by 13.5 ? ? $1,350

Inflation Refers to an INCREASE in the price level from one period to the next. Inflation can be high (20%) or low (2%) When inflation drops (say from 20% to 2%) prices still INCREASE. 28

Deflation Refers to a DECREASE in the price level from one period to the next. Deflation results in a NEGATIVE inflation rate. Describes a DROP in prices. 30

Problems Measuring the Cost of Living 1.Substitution Bias: Because the basket is fixed, the CPI does not account for substitutions consumers do in response to higher prices. 32

33 4 Frozen Desserts 3 Fruits New Ignores substitution away from “frozen” to “cake-like” desserts 4 ice creams 3 apples Old New Basket: More General Categories

Problems with CPI… 2.New Goods not included in the basket allow consumers to attain the same (or higher) standard of living at lower cost. 3.Unmeasured Quality change: If quality improves, a dollar buys more MB floppy to 256 Gb flash drive

Chained CPI Utilizes expenditures in both the current and base time periods in order to reflect the effect of any substitution that consumers may make across item categories in response to changes in relative prices. On average, the chained CPI is less than the conventional CPI by 0.25 to 0.3 percentage points. The Bureau of Labor Statistics has been tracking chained CPI since 2002.

GDP Deflator vs. CPI Reflects prices of ALL goods and services produced purchased by Consumers, Firms, Government, Other countries. 36

The GDP Deflator vs. CPI GDP Deflator Uses a basket with different goods and different quantities Uses current production items and quantities. CPI Uses a basket with same goods and same quantities Uses the Market Basket 37

Inflation Calculator This site finds the equivalencies for dollars in different years. 38

Measuring Prices The Consumer Price Index (CPI) measures inflation as experienced by consumers in their day-to-day living expenses The Producer Price Index (PPI) measures inflation at earlier stages of the production process The Employment Cost Index (ECI) measures inflation in labor costs The BLS International Price Program measures price changes for imports and exports The Gross Domestic Product Deflator (GDP Deflator) measures inflation experienced by both consumers themselves as well as governments and other institutions providing goods and services to consumers. 39

Employment Cost Index (ECI) Average Hourly Earnings (AHE) ECI comes out quarterly and measures changes in employee wages, salaries and benefits. AHE, the Employment Situation report, comes out monthly, shows how worker wages are changing month to month. Both are important because rapidly rising labor costs can force businesses to raise prices to compensate, spurring inflation. For the most recent ECI data, click here. For the most recent AHE data, click herehere