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Lecture 2:
Comparing GDP over Time
September 2, 2014
Prof. Wyatt Brooks
MEASURING A NATION’S INCOME
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US GDP per capita: 1929-2012
51200
25600
Bread, Chicago
2012: $3.55
12800
6400
3200
1600
Bread, Chicago
1929: 10¢
800
400
1929
1949
MEASURING THE COST OF LIVING
1969
1989
2009
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Real versus Nominal GDP
 Inflation is the reduction in the purchasing power
of the currency over time
 Inflation can distort economic variables like GDP,
so we have two versions of GDP:
One is corrected for inflation, the other is not.
 Nominal GDP values output using current prices.
It is not corrected for inflation.
 Real GDP values output using the prices of
a base year. Real GDP is corrected for inflation.
MEASURING A NATION’S INCOME
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The GDP Deflator
 The GDP deflator is a measure of the overall
level of prices.
 Definition:
nominal GDP
GDP deflator = 100 x
real GDP
 One way to measure the economy’s inflation
rate is to compute the percentage increase in
the GDP deflator from one year to the next.
MEASURING A NATION’S INCOME
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ACTIVE LEARNING
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Computing GDP
2007 (base yr)
P
Good A
Good B
$30
$100
Q
2008
P
2009
Q
900 $31 1,000
192 $102
200
P
Q
$36
$100
1050
205
Use the above data to solve these problems:
A. Compute nominal GDP in 2007.
B. Compute real GDP in 2008.
C. Compute the GDP deflator in 2009.
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ACTIVE LEARNING
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Answers
2007 (base yr)
P
Good A
Good B
$30
$100
Q
2008
P
2009
Q
900 $31 1,000
192 $102
200
P
Q
$36
$100
1050
205
A. Compute nominal GDP in 2007.
$30 x 900 + $100 x 192 = $46,200
B. Compute real GDP in 2008.
$30 x 1000 + $100 x 200 = $50,000
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ACTIVE LEARNING
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Answers
2007 (base yr)
P
Good A
Good B
$30
$100
Q
2008
P
2009
Q
900 $31 1,000
192 $102
200
P
Q
$36
$100
1050
205
C. Compute the GDP deflator in 2009.
Nom GDP = $36 x 1050 + $100 x 205 = $58,300
Real GDP = $30 x 1050 + $100 x 205 = $52,000
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x ($58,300)/($52,000) = 112.1
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The Consumer Price Index (CPI)
 GDP Deflator includes the effect of investment
goods, imports, exports and so on…
 Not closely tied to the prices that consumers face
 Use the Consumer Price Index
 A measure of how much it costs to maintain
your standard of living
 the basis of cost of living adjustments (COLAs) in
many contracts and in Social Security
MEASURING THE COST OF LIVING
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How the CPI Is Calculated
1. Fix the “basket.”
The Bureau of Labor Statistics (BLS) surveys
consumers to determine what’s in the typical
consumer’s “shopping basket.”
2. Find the prices.
The BLS collects data on the prices of all the
goods in the basket.
3. Compute the basket’s cost.
Use the prices to compute the total cost of the
basket.
MEASURING THE COST OF LIVING
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How the CPI Is Calculated
4. Choose a base year and compute the index.
The CPI in any year equals
100 x
cost of basket in current year
cost of basket in base year
5. Compute the inflation rate.
The percentage change in the CPI from the
preceding period.
Inflation
=
rate
CPI this year – CPI last year
CPI last year
MEASURING THE COST OF LIVING
x 100%
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What’s in the CPI Basket?
Housing
3.7%
3.5%
Transportation
6.4%
Food & Beverages
6.5%
42.0%
6.5%
Medical care
Recreation
14.8%
16.7%
Education and
communication
Apparel
Other
MEASURING THE COST OF LIVING
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Two Measures of Inflation, 1950-2010
MEASURING THE COST OF LIVING
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Producer Price Index (PPI)
 The equivalent of CPI, but the basket of goods is
based on what firms purchase
 Because costs are passed on, CPI and PPI
move together
15.00%
PPI
10.00%
CPI
5.00%
0.00%
1948
1956
1964
1972
1980
1988
1996
2004
2012
-5.00%
MEASURING THE COST OF LIVING
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Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times
Amount
in today’s =
dollars
Amount
in year T
dollars
MEASURING THE COST OF LIVING
x
Price level today
Price level in year T
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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.
 Example: the minimum wage
 $1.15 in Dec 1964
 $5.85 in Dec 2007
 Did minimum wage have more purchasing power
in Dec 1964 or Dec 2007?
MEASURING THE COST OF LIVING
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The U.S. Minimum Wage in Current Dollars
and 2009 Dollars, 1938-2010
ACTIVE LEARNING
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Converting to “today’s dollars”
Annual tuition and fees, average of all public fouryear colleges & universities in the U.S.
 1986-87: $1,414 (1986 CPI = 109.6)
 2006-07: $5,834 (2006 CPI = 203.8)
After adjusting for inflation, did students pay more for
college in 1986 or in 2006? Convert the 1986 figure
to 2006 dollars and compare.
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ACTIVE LEARNING
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Answers
Annual tuition and fees, average of all public fouryear colleges & universities in the U.S.
 1986-87: $1,414 (1986 CPI = 109.6)
 2006-07: $5,834 (2006 CPI = 203.8)
Solution
Convert 1986 figure into “today’s dollars”
$1,414 x (203.8/109.6) = $2,629
Even after correcting for inflation, tuition and fees
were much lower in 1986 than in 2006!
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Correcting Variables for Inflation:
Indexation
A dollar amount is indexed for inflation
if it is automatically corrected for inflation
by law or in a contract.
For example, the increase in the CPI automatically
determines
 the COLA in many multi-year labor contracts
 the adjustments in Social Security payments
(since 1975) and federal income tax brackets
(since 1985)
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Correcting Variables for Inflation:
Cost of Living Adjustments (COLA)
MEASURING THE COST OF LIVING
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Problems with the CPI:
Substitution Bias
 Over time, some prices rise faster than others,
hence relative prices change.
 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 cost of
living.
MEASURING THE COST OF LIVING
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Problems with the CPI:
Introduction of New Goods
 The introduction of new goods increases variety,
allows consumers to find products that more
closely meet their needs.
 In effect, dollars become more valuable.
 The CPI misses this effect because it uses a
fixed basket of goods.
 Thus, the CPI overstates increases in the cost of
living.
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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, 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 COLAs tied
to the CPI.
MEASURING THE COST OF LIVING
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Correcting Variables for Inflation:
Real vs. Nominal Interest Rate
The nominal interest rate:
 the interest rate not corrected for inflation
 the rate of growth in the dollar value of a
deposit or debt
The real interest rate:
 corrected for inflation
 the rate of growth in the purchasing power of a
deposit or debt
Real interest rate
= (nominal interest rate) – (inflation rate)
MEASURING THE COST OF LIVING
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Correcting Variables for Inflation:
Real vs. Nominal Interest Rate
Example:




Deposit $1,000 for one year.
Nominal interest rate is 9%.
During that year, inflation is 3.5%.
Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
 The purchasing power of the $1000 deposit
has grown 5.5%.
MEASURING THE COST OF LIVING
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Real and Nominal Interest Rates in the U.S.,
1950-2010
MEASURING THE COST OF LIVING
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Quick Intro to the Federal Reserve Bank
 The Federal Reserve Bank of the United States
is the monetary authority of the USA.
 Monetary Authority: Government body
responsible to determining how much money is
in the economy
 Examples: US Federal Reserve ($), European
Central Bank (€), Bank of England (£), People’s
Bank of China (元), Bank of Japan (¥)
 One goal of the Federal Reserve: price stability
 The Federal Reserve was created on
December 23, 1913
MEASURING THE COST OF LIVING
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US Price Level (CPI) relative to 1913
2500%
2000%
1500%
1000%
500%
0%
1913
1923
1933
1943
1953
MEASURING THE COST OF LIVING
1963
1973
1983
1993
2003
2013
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CPI Annual Changes over Time
40.00%
30.00%
20.00%
10.00%
0.00%
1912
1932
1952
1972
1992
2012
-10.00%
-20.00%
-30.00%
-40.00%
MEASURING THE COST OF LIVING
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Inflation Measure: 1701-1914
40.00%
30.00%
20.00%
10.00%
0.00%
1701
1751
1801
1851
1901
-10.00%
-20.00%
-30.00%
-40.00%
Source: John McCusker, “How Much is That in Real Money?”,
Proceedings of the American Antiquarian Society (2001)
MEASURING THE COST OF LIVING
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Next Class
 Growth over the long run
 Read Mankiw chapter 12
 Make sure to do the first two sections of the
homework based on the lectures
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