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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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