Ag_Econ 1042 1st Edition Lecture 5 Outline of Last Lecture I. Gross Domestic ProductII. The Expenditure ApproachIII. Real GDP Vs. Nominal GDPa. GDP Deflatorb. GDP Per Capita IV. GDP Limitations Outline of Current Lecture I. The Importance of PricesII. The Market Basketa. Consumer Price IndexIII. Challenges When Measuring PriceIV. Using the Price Indicesa. Inflation rateb. Deflating nominal variablec. Adjusting for InflationV. Purchasing Power IndexesCurrent LectureI. The Importance of PricesPrices and how they change are a big part of macroeconomics. Prices are changing at different speeds in different places. For example, gas prices in the Mid-West are cheaperthan those in Northern New York. Changes in price can influence consumer incentives, income, cost of living and other things. Price changes also effect firms because if consumer incomes are remaining the same the only way firms can make more money is by attracting more consumers. But if consumer incomes are increasing, firms can make more money without having to try to bring in more consumers.II. The Market BasketIn order to compare the cost of living in different places the goods and services compared must be common in each place. Those goods and services are included in the market basket.The market basket is a fixed list of goods and services in fixed quantities. The goods and services are kept in fixed quantities so only price changes are shown. The market basket is handy for price indices, which show how much the prices of the goods and services in the market basket have changed compared to its base year or compared to another location. The most commonly used price index is the Consumer Price Index, also known as the CPI. The CPI, measured by the Bureau of Labor Statistics, keeps watch of the price change of the market basket for a typical household in The Unites States. During the base year, CPI always equals one hundred, but if the CPI rises above one hundred between any two year that means that prices have increased, and if it decreases then prices are less than what they were during the base year. To calculate CPI divide the market basket cost of the desired year by the basket cost in the base year, then multiply that dividend by one hundred.III. Challenges When Measuring PriceThere are two main issues when measuring price, the first being how to decide which goods and services to include in the market basket. Since a single number cannot be used to precisely describe peoples’ cost of living the Bureau of Labor Statistics considers what a typical household consumes. A typical household includes urban consumers, which may exclude individuals that live in a rural area or even military families. The second challenge deals with the inconsistency of consumer actions. For each consumer has a different incentive, therefore not every consumer will make the same decision. With technology improvements and innovation in general, consumers will change what they consume. While CPI keeps quantity the same it does not take consumption changes into account.IV. Using The Price IndicesPrice indices have the ability to change nominal values to real values by isolating the change.The size of the change in overall price level is known as the inflation rate. To find inflation rate, subtract the CPI of the earliest year from the CPI of the more recent year, divide that bythe CPI of the earliest, and then multiply that dividend by one hundred. When the inflation rate is negative it is said that deflation occurred.There are 2 ways to report inflation with the consumer price index, with headline inflation and core inflation. Headline inflation is a measure of how prices change for the entire market basket. Whereas core inflation is the measurement of price changes without food and energy costs. Core inflation is very useful because food and energy cost change very often, and they could overstate or understate the actual change in overall prices. Then thereis the producer price index, also known as PPI that measures the prices of goods and services that firms purchase. Lastly, there is the GDP deflator that measures the prices of goods and services produced in the country.Any price index can change a nominal value to a real value. For example, using CPI multiply the nominal year value of year “X” by the CPI of year “Y” over the CPI of year “X” to get the real value of year “Y”. This allows the comparison of purchasing powers over time. It is said that wages should increase naturally to make up for inflation, but there are some times when inflation occurs so rapidly that wages are slower to catch up. That is why indexing occurs, when payments automatically increase in proportion to the cost of living, “cost-of-living adjustments”.V. Purchasing Power IndexesPurchasing power indexes help explain why there are price differences in different locations.Purchasing power parity is a theory stating that purchasing power in different countries should be the same when explained in the same currency. However this rarely occurs due totransaction costs, non-tradables and trade restrictions. The purchasing power parity adjustment recalculates the economic statistics to take account of the differences in the price levels across different countries. To find the PPI-adjusted GDP multiply the nominal dollars of a country by the dividend of one over one minus the price level adjustment of thatcountry. This is used to account for differences in purchasing powers of different