Zara Mahmood September 10 13 EC102 Lecture 2 Gross Domestic Product GDP Measuring the Price Level P Price Level A measure of the average prices of goods and services in the economy GDP deflator is a measure of price level Increases in the GDP deflator allow economists to track increases in the price level over time Inflation Rate The percentage increase in the price level from one year to the next The GDP Deflator Ratio of nominal GDP to real GDP times 100 GDP Deflator nominal GDP real GDP x 100 o The deflator 100 when nominal and real are the same o This number would come from the base year o Includes stuff that we buy and stuff that most people would not buy GDP Deflator for 2012 o 15 7T 13 6T x 100 115 o 115 No meaning The number becomes useful when comparing to other years Example Calculating the GDP Deflator Nominal GDP Year Real GDP GDP Deflator 2005 2006 2007 6 000 8 250 10 800 6 000 7 200 8 400 100 0 114 6 128 6 P stands for the price level measured by CPI or GDP inflator percentage change in P P o P in later year P in earlier year p in earlier year x 100 Example Calculating Inflation with the GDP Deflator Year Nominal GDP Real GDP GDP Deflator Inflation 2005 2006 2007 6 000 8 250 10 800 6 000 7 200 8 400 100 0 114 6 128 6 14 6 12 2 The Consumer Price Index CPI Consumer Price Index CPI An average of the prices of the goods and services purchased by the typical urban family of four The CPI tracks almost identically with the average nominal wage Measures changes in the prices of things that an average consumer buys o Only focuses on products that average consumer buys Zara Mahmood September 10 13 EC102 The most closely watched indicator of what is happening to prices Release of a new CPI number can have a big impact on financial markets o Calculated by the Bureau of Labor Statistics BLS o Released in the middle of the month Used for a lot of different things o Number that tracks changes in the typical household s cost of living o Adjusts many contracts for inflation COLAs o Allows comparisons of dollar amounts over time Translate dollar value equivalence to present day How does the BLS construct the CPI Survey consumers to determine compositions of the typical consumer s basket of goods o Roughly 30 000 households are surveyed Every month collect data on prices of all items in the basket o Compute cost of basket Choose a base year currently an avg of prices from 1982 1984 Calculate the CPI in a given month as follow o cost of basket in that month cost of basket in base period x 100 Basket of goods for average consumer urban not rural Example Calculating the CPI Basket 20 pizzas 10 CDs PPizza PCDs Cost of Basket CPI Inflation 15 15 350 370 100 105 7 5 7 Year 2002 2003 10 11 Zara Mahmood September 10 13 EC102 2004 2005 12 13 16 15 400 410 114 3 117 1 8 1 2 4 Calculating inflation rate with CPI o CPI in later year CPI in earlier year CPI in earlier year x 100 Inflation going down is different than prices going down disinflation slower price level CPI goes down prices are falling inflation is negative CPI vs GDP Deflator CPI Includes only goods typically bought by consumers Includes imported goods Uses a fixed basket of goods GDP Deflator Includes all goods Does not include imports only stuff produced domestically o Problem So much of what we buy is imported goods Used a changing basket of goods Is the CPI Accurate Most widely used measure of inflation o 4 biases that cause changes in the CPI to overstate the true inflation rate Biases cause changes in CPI to overstate the true inflation rate by 0 5 1 Substitution Bias BLS assumes that each month consumers purchase the same amount of each product in the market basket consumers are likely to buy fewer of those products that increase most in price and more that increase least in price or fall Price of market basket will rise less than price BLS uses to compute CPI Increase in Quality Bias Most products included in the CPI improve in quality Increase in prices of these products partly reflects their improved quality and partly pure inflation BLS tries to only account of inflation part but that is difficult o Recorded price increases overstate the pure inflation in some products New Product Bias BLS updated market basket of goods used in computing CPI every 10 years New products introduced between updates were not included Price of new products decrease in the years immediately after release Zara Mahmood September 10 13 EC102 o If market basket is not updated frequently these price decreases are not included in CPI Outlet Bias 1990s many consumers started to increase their purchases from discount stores Internet also began to account for a fraction of sales of some products BLS collects price statistics from fill price traditional retailers o CPI did not reflect the prices some consumers actually paid The Producer Price Index Producer Price Index PPI An average of the prices received by producers of goods and services at all stages of the production process CPI tracks prices of goods services bought by household PPI tracks prices firms receive for goods services at all production stages o Raw material intermediate goods final products Price of goods rise production cost to firms rise increase price of goods o Changes in PPI can give early warnings to changes in CPI Using Price Indexes to Adjust for the Effects of Inflation Purchasing power of a dollar was much higher in the past because prices of goods were lower CPI give us a way of adjusting for the effects of inflation so that we can compare different years dollar values Value in 2010 Value in 1984 x CPI 2010 CPI 1984 o 20 000 x 219 104 42 115 o 20 000 salary in 1984 42 115 in 2010 This adjusts nominal values for the effects of inflation The Costs of Inflation Inflation raises prices but it doesn t mean consumers can t afford goods As prices increase income does as well o Consumers should be just as able to by products with inflation as they would without inflation Then why is inflation bad Distributional effects Some workers incomes will not keep up with inflation o Applies to average person but not every person Some income rise faster than inflation some income slower than inflation Shoeleather costs The resources wasted when inflation encourages people to reduce their money holdings o People buy stuff fast because the price could be more the next day o Includes the time and transactions costs of more frequent bank withdrawals Menu costs The costs of changing prices Zara