Econ 2: Introduction to
Macroeconomics
Lint Barrage, UCSB, Spring 2022
March 28 & 30, 2022
Plan
1. Introductions
2. Syllabus Review
3. Intro to Macroeconomics:
Defining and Measuring Macroeconomic Aggregates (Chapter 5)
Introductions: Instructor
• Prof. Lint Barrage
• Ph.D. in Economics from Yale University
•
•
Specialization: Intersection of macroeconomics, energy/environmental systems, public finance
E.g.: Economic growth, fiscal impacts of natural disasters, shale gas revolution, climate change/policy, etc.
• Before UCSB, taught at:
• Brown University
• University of Maryland
• I became an economist because I wanted to better understand and contribute to public policy.
• Economics provides amazing opportunities to speak to decision‐makers!
•
E.g., Congressional Budget Office, Federal Reserve, G20, IMF, World Bank, etc.
 What are your interests?
TAs
Ravi Vora
Sonal Barve
Richard Uhrig
Yihong Liu
Camila Paleo
Annika Ziegler
Reetika Sindhi
Fatiq Nadeem
Plan
1. Introductions
2. Syllabus Review
3. Intro to Macroeconomics:
Defining and Measuring Macroeconomic Aggregates (Chapter 5)
Plan
1. Introductions
2. Syllabus Review
3. Intro to Macroeconomics:
Defining and Measuring Macroeconomic Aggregates (Chapter 5)
Intro to Macroeconomics – Spring 2022
Learning Objectives
1. Macroeconomic Questions
2. National Income Accounts: Production = Expenditure = Income
3. What is – and isn’t – measured by GDP
4. What is inflation? Real vs. Nominal GDP
Macroeconomics
“Macroeconomics is the study of economic aggregates and economy‐wide
phenomena like the annual growth rate of a country’s total economic output or the
annual percentage increase in the total cost of living.”
Macroeconomic Questions‐ Traditional
• What is a country’s total or per capita output?
• Why are some countries rich and others poor?
• What causes economic growth (in the short‐run and long‐run)?
• What causes recessions (= two straight quarters in which aggregate income falls)?
• What drives unemployment?
• What drives inflation?
• What are the effects of fiscal policy (e.g., taxes, stimulus)?
• What are the effects of monetary policy (i.e., Central Bank activity)?
• What role does the financial system play in affecting the real economy?
Macroeconomic Questions
United States: Annual per capita income
$65,000 (2019)
Mali: Annual per capita income:
$890 (2019)
“Once you start thinking about [economic] growth, it’s hard to think about anything else.”
~ Robert Lucas, Nobel Prize‐winning economist
Macroeconomic Questions‐ New*
• Modern macroeconomics considers an even broader set of questions – examples:
• How will climate change affect the economy? How can we balance the costs and
benefits of reducing greenhouse gas emissions? (Nordhaus, 1975,…,2017)
• What are the economic benefits of (reducing) discrimination barriers against women
and minorities in occupational choice (i.e., better talent allocation)? (Hsieh et al., 2019)
• How do public investments in early childhood education programs affect adult wages,
income mobility, and the macroeconomy? (Daruich, 2018)
• How does the criminal justice system affect human capital accumulation, employment,
inequality, and the macroeconomy? (Guler and Michaud, 2018)
• How is income growth distributed across income groups? Who benefits how much
from aggregate growth? (Piketty, Saez, and Zucman, 2018)
New Macro: Climate Change*
• William D. Nordhaus: Awarded Nobel Prize for ““integrating climate change into long‐
run macroeconomic analysis”
• Climate change affects entire world  Definitely a “macro” issue
• Has been calling for climate policy since 1970s
• Nordhaus’ (and others’) climate‐macroeconomic models used to quantify the “social
cost of carbon” emissions by U.S. and other governments
• Carbon prices used in climate policy
around the world
Map Source: World
Bank (2021)
New Macro: Reducing Discrimination*
• Hsieh, Hurst, Jones, and Klenow (2019) estimate that the improvement in talent
allocation to jobs due to reduced discrimination against women and minorities
accounted for 40% of U.S. GDP growth since the 1960s
Figures source: Hsieh et al. (2019)
Measuring the Aggregate Economy
• In order to answer any questions about the aggregate economy, we first have
to be able to measure it!
• 20th Century saw development of measurement methods:
• National income accounts: A framework to measure the level of aggregate
economic activity in a country
• National Income and Product Accounts (NIPA): The United States’ system of
national income accounts
National Income Accounts
Aggregate economic activity in a country can be measured in three different ways:
• The production approach
• The expenditure approach
• The income approach
• We’ll first illustrate each approach using a toy example and then talk about GDP
The Production Approach
• Idea: Sum up the market value of the final goods and services produced in a year
• Toy example: Appleville is a small country with one employer, Apple Farms, which
produces 10 million apples a year. The market price of an apple is $2.
• All of Appleville’s citizens are workers in the farm.
• Apple Farms owns its land and machines so only needs to hire workers.
The Production Approach
• To determine the market value of production, we multiply the quantity of apples
produced by the market price of each apple:
Production = (10 million apples) × ($2.00 / apple) = $20 million
The Expenditure Approach
• Idea: Sum up the sales of apples to households:
• Expenditure = (10 million apples) × ($2.00 / apples) = $20 million
The Income Approach
• Idea: Sum up income payments to labor (workers) and to capital (machines, land):
• Apple Farm generates $20 million in revenue, pays $X to its workers, and keeps ($20
million ‐ $X) for its owners. So, total income for its workers and owners is:
Income = $X + ($20 million ‒ $X) = $20 million
Aggregate Accounting Identity
• In sum, each of our three approaches thus yields the same result:
• Production = Expenditure = Income
• $20 million = $20 million = $20 million
Gross Domestic Product (GDP)
• Each of these approaches is used to measure gross domestic product.
• GDP: “The market value of the final goods and services produced within
the borders of a country during a particular time period.”
Gross Domestic Product (GDP)
• Each of these approaches is used to measure gross domestic product.
• GDP: “The market value of the final goods and services produced within
the borders of a country during a particular time period.”
Gross National Product (GNP)
• GDP: The market value of the final goods and services produced within the borders of
a country during a particular time period.
• GNP: The market value of production generated by the factors of production owned
by the residents of a country.
Gross National Product (GNP)
• GNP: “The market value of production generated by the factors of production owned by the
residents of a country.”
• E.g.: If a U.S. citizen holds a summer job in Canada, their labor earnings count towards U.S.
GNP (since it is value created by a U.S. resident) but NOT U.S. GDP (since the production did
not occur within the U.S.)
• Their labor earnings count towards Canadian GDP (since they produced in Canada) but NOT
Canadian GNP (since they are not a Canadian citizen)
• GNP often used interchangeably with “Gross National Income” (GNI)
• For the U.S., GDP and GNP are similar: $21.4 trillion vs. $21.7 trillion (2019)
Practice: GDP vs. GNP
Simone is a citizen of Lebanon studying in the U.S. During her freshman year, she
worked in the campus dining hall, earning $5,000. This income counts towards:
• US GDP?
• US GNP?
• Lebanese GDP?
• Lebanese GNP?
Practice: GDP vs. GNP
Simone is a citizen of Lebanon studying in the U.S. During her freshman year, she
worked in the campus dining hall, earning $5,000. This income counts towards:
• US GDP? Yes
• US GNP? No
• Lebanese GDP? No
• Lebanese GNP? Yes
GDP: Production Approach
• GDP: “The market value of the final goods and services produced within
the borders of a country during a particular time period.”
• “Final”  Value end of production chain: Value‐added
• Value‐added: Sales revenue minus the firm’s purchases of intermediate
products from other firms (to avoid double‐counting)
• Note: No intermediate products in our Appleville example
GDP: Production Approach
Example on Value‐Added
• Starbucks sales revenue per cup of coffee: $2.00
• Starbucks intermediate goods purchases (coffee beans, paper cups, lids,
etc.): $0.25 per cup
• Value‐added = $2.00 ‐ $0.25 = $1.75 per cup
GDP: Production Approach
• The Production Approach sums up all firms’ value‐added
• How is this actually done in practice?
• U.S. Bureau of Economic Analysis (BEA) compiles data from a
variety of sources, e.g.:
GDP: Production Approach
• Again: Why can’t we just sum up sales across firms? Why do we have to bother with
value added?
• Example: Value added for 1 jar of peanut butter
Stage of Production
Sale Price
Intermediate
Value Added
Peanut farmer
$0.50
‐‐
$0.50
Manufacturer
$1.20
$0.50
$0.70
Wholesaler
$1.50
$1.20
$0.30
Grocery
$2.00
$1.50
$0.50
TOTAL
$5.20
$2.00
 Sum of value added ($2.00) = market value of the final product ($2.00)
Practice Problem: Value Added
Practice Problem: Value Added
• U.S. mines: $5 billion in value added
• U.S. smartphone company: $34‐$28 billion = $6 billion in value added (Hint: Inventory = sales to itself!)
• U.S. retailers: $31‐$25 billion = $6 billion in value added
GDP: Expenditure Approach
• Sum up purchases of goods and services produced across categories:
1. Consumption goods and services bought by domestic households (C)
GDP: Expenditure Approach
• Sum up purchases of goods and services produced across categories:
1. Consumption goods and services bought by domestic households (C)
2. New physical capital (investment) bought by dom. households and dom. firms (I)
GDP: Expenditure Approach
• Sum up purchases of goods and services produced across categories:
1. Consumption goods and services bought by domestic households (C)
2. New physical capital (investment) bought by dom. households and dom. firms (I)
3. Government expenditures on goods and services (G)
GDP: Expenditure Approach
• Sum up purchases of goods and services produced across categories:
1. Consumption goods and services bought by domestic households (C)
2. New physical capital (investment) bought by dom. households and dom. firms (I)
3. Government expenditures on goods and services (G)
4. Exports of goods and services produced domestically and sold abroad (X)
GDP: Expenditure Approach
• Sum up purchases of goods and services produced across categories:
1. Consumption goods and services bought by domestic households (C)
2. New physical capital (investment) bought by dom. households and dom. firms (I)
3. Government expenditures on goods and services (G)
4. Exports of goods and services produced domestically and sold abroad (X)
5. [Minus] Imports of goods and services produced abroad and sold domestically (M)
GDP: Expenditure Approach
• National Income Accounting Identity: GDP (Y) is given by total value of expenditures on
goods and services produced in the domestic economy:
Y = C +I +G +X -M
• Subtract imports (M) since GDP is only meant to measure value of goods and services
produced in the domestic economy
• Note: Net exports [X‐M] tells us country’s trade balance
•
Trade surplus if Exports X > Imports M
•
Trade deficit if Exports X < Imports M
The Wealth of Nations: Defining and
Measuring Macroeconomic Aggregates
2019 U.S. GDP
Copyright © 2018, 2015 Pearson Education, Inc. All Rights Reserved
The Wealth of Nations: Defining and
Measuring Macroeconomic Aggregates
U.S. GDP Shares (1929–2019)
Copyright © 2018, 2015 Pearson Education, Inc. All Rights Reserved
GDP: Income Approach
• Labor Income: Any form of payment that compensates people for their work: wages,
workers’ health insurance, pension benefits, free parking spaces at work, etc.
• Capital Income: Any form of payment that derives from owning physical or financial
capital: dividends paid to shareholders, interest paid to lenders, rent paid to landlords,
benefits from living in your own house, etc.
• Income‐based accounting sums up all payments received by labor and the owners of
physical or financial capital.
Labor Share of GDP Over Time (U.S.)*
Capital Income*
Capital Income*
Capital Income*
Recap
• Aggregate Accounting Identity:
Y = GDPPROD = GDPEXP = GDPINCOME
• National Income Accounting Identity:
Y = C +I +G +X -M
Aside: Saving
• We can use the National Income Accounting Identity to study aggregate saving
• Savings (S) = Income – expenditures
S=Y–C–G
• Plugging in from the National Income Accounting Identity for Y yields:
S = [C+I+G+X‐M] – C –G
S = I + X –M
Saving = Investment + Exports ‐ Imports
Aside: Saving
Saving = Investment + Exports – Imports
• Two key lessons (for now):
1) Savings and investment are closely related (as X‐M often small)
US data: 1929‐2013
Aside: Saving
Saving = Investment + Exports – Imports
• Two key lessons (for now):
2) Countries that run a trade deficit also invest more than they save (i.e., borrow)
[Investment – Savings] = [Imports – Exports]
>0
if
>0
• “Twin Deficits” in Budget and Trade – more on this later in macro!
What Isn’t Measured in GDP?
“GDP and national income accounting is a useful system for
taking the temperature of the economy. However, it is not
perfect, and it necessarily leaves out a lot of details.”
What Isn’t Measured in GDP?
1. Home Production: Cleaning, cooking, child care, gardening, elderly care,
etc. done in the household
• Likely big omission: Tens of millions work in home; most who
are formally employed engage in household production, too.
•“GDP goes down if you marry your gardener”
• Challenge: Hard to measure! US BEA has explored topic
using new data from American Time Use Survey (2003+)
What Isn’t Measured in GDP?
2. Underground Economy: Transactions deliberately hidden from government
• Illegal drug sales, jobs paid “under the table” (cash), etc.
• Illegal drug sales in U.S. estimated to amount to around 1% of GDP –
equivalent to value of all agricultural production!
• Total value of underground economy estimated around 10% of GDP (in U.S.)
What Isn’t Measured in GDP?
3. Capital Depreciation: GDP omits depreciation of the physical capital stock
and natural resources.
What Isn’t Measured in GDP?
4. Leisure: GDP accounts give the economy no credit for producing leisure.
What Isn’t Measured in GDP?
5. Inequality: Standard GDP measures focus on aggregate income and do not
reflect the distribution of income across households.
• Some economists have recently developed “Distributional National Accounts” that keep track
of this distribution, e.g., Piketty et al. (2016):
• Note: The methodologies underlying
these distributional accounts are subject
to an active debate and disagreement
What Isn’t (Properly) Measured in GDP?(*)
6. Externalities: When activities create spillover costs or benefits to third
parties, we call this an externality (e.g., pollution from a power plant,
contribution to herd immunity from vaccines, etc.)
• These costs or benefits are typically either omitted from GDP (e.g., visual
amenity from beautiful garden, holiday lights, cute dog in the park, etc.)
• Or they affect GDP in the “wrong” way:
‐ Increased health expenditures due to pollution increase GDP
‐ Decreased health expenditures due to herd immunity decrease GDP
GDP and Human Well‐Being
• GDP has many flaws – but can it proxy for human well‐being?
GDP and Human Well‐Being*
Aside: Correlation vs. Causation*
• ALWAYS keep in mind: Correlation does NOT necessarily imply causation!
• If A and B are correlated, there are several possibilities:
1. A causes B
2. B causes A
3. A third factor C causes both A and B
Aside: Correlation vs. Causation*
• ALWAYS keep in mind: Correlation does NOT necessarily imply causation!
• In our example of GDP (“A) and life expectancy (“B”):
• Maybe higher GDP causes higher life expectancy (better healthcare)
• Maybe health causes higher GDP (healthier people produce more)
• Maybe a third factor – such as better government – cause both higher GDP
and better health outcomes
Aside: Correlation vs. Causation*
• ALWAYS keep in mind: Correlation does NOT necessarily imply causation!
• You see politicians, news media, even
researchers treat correlations as causal
all the time – be a savvy reader and citizen!
• Important note: There are scientific and
statistical methods for teasing out causation.
You will learn some of these if you take
Econometrics, for example.
Real vs. Nominal GDP
• Critically important concept not just for GDP but for policy & personal finance!
• Let’s go back to Appleville where the 2019 GDP was:
GDP_Production = (10 million apples) × ($2.00 / apple) = $20 million
• Imagine I tell you that, in 2020, GDP increased to $30 million – is this good news?
Real vs. Nominal GDP
• Critically important concept not just for GDP but for policy & personal finance!
• Let’s go back to Appleville where the 2019 GDP was:
GDP_Production = (10 million apples) × ($2.00 / apple) = $20 million
• Imagine I tell you that, in 2020, GDP increased to $30 million – is this good news?
• Possibility A: (15 million apples) x ($2.00/apple) = $30 million
Real vs. Nominal GDP
• Critically important concept not just for GDP but for policy & personal finance!
• Let’s go back to Appleville where the 2019 GDP was:
GDP_Production = (10 million apples) × ($2.00 / apple) = $20 million
• Imagine I tell you that, in 2020, GDP increased to $30 million – is this good news?
• Possibility A: (15 million apples) x ($2.00/apple) = $30 million
• Possibility B: (10 million apples) x ($3.00/apple) = $30 million
• Possibility C: (8 million apples) x ($3.75/apple) = $30 million
• Possibility C: (12 million apples) x ($2.50/apple) = $30 million
Real vs. Nominal GDP
Nominal GDP: The total value of production using current market prices to
determine the value of each unit that is produced
• An increase in GDP will record both increases in actual production and increases in
the prices of goods and services
 Real GDP: The total value of production using constant market prices – that is,
from a specific base year – to determine the value of each unit that is produced
Real vs. Nominal GDP
• Nominal 2019 Appleville GDP:
(10 million apples) × ($2.00 / apple) = $20 million
• Nominal 2020 Appleville GDP:
(12 million apples) x ($2.50/apple) = $30 million
• Real 2020 Appleville GDP: Value year 2020 production at constant (year 2019) prices!
(… million apples) × ($…/apple) = …
Real vs. Nominal GDP
• Nominal 2019 Appleville GDP:
(10 million apples) × ($2.00 / apple) = $20 million
• Nominal 2020 Appleville GDP:
(12 million apples) x ($2.50/apple) = $30 million
• Real 2020 Appleville GDP: Value year 2020 production at constant (year 2019) prices!
(12 million apples) × ($2.00/apple) = $24 million
Year 2020 quantity
Year 2019 price
Real vs. Nominal GDP
• Key idea: To make a meaningful comparison between GDP in 2019 and 2020, we value
output in both years using the same prices (e.g., using 2019 as base year)
• Why not just look at quantities (e.g., number of apples produced) to measure production?
• Might work in Appleville, but consider real economy producing many different goods:
• 2019 Nominal GDP: 𝑄
·𝑃
)+ 𝑄
·𝑃
𝑄
·𝑃
)+…
• 2020 Nominal GDP: 𝑄
·𝑃
)+ 𝑄
·𝑃
𝑄
·𝑃
)+…
GDP Growth
• GDP growth is a key measure of how the economy is doing
GDP growth in 2020 =
• Real GDP growth is calculated using real GDP
• Nominal GDP growth is calculated using nominal GDP
GDP Growth in Appleville
• Nominal 2019 GDP: (10 million apples) × ($2.00 / apple) = $20 million
• Nominal 2020 GDP: (12 million apples) x ($2.50/apple) = $30 million
• Real 2020 GDP (2019 base year): (12 million apples) × ($2.00 / apple) = $24 million
What was Appleville’s nominal GDP growth in 2020?
GDP Growth in Appleville
• Nominal 2019 GDP: (10 million apples) × ($2.00 / apple) = $20 million
• Nominal 2020 GDP: (12 million apples) x ($2.50/apple) = $30 million
• Real 2020 GDP (2019 base year): (12 million apples) × ($2.00 / apple) = $24 million
What was Appleville’s nominal GDP growth in 2020?
𝐺𝐷𝑃 𝑖𝑛 2020
𝐺𝐷𝑃 𝑖𝑛 2019
𝐺𝐷𝑃 𝑖𝑛 2019
$30 𝑚𝑖𝑙.
$20 𝑚𝑖𝑙.
$20 𝑚𝑖𝑙.
50%
GDP Growth in Appleville
• Nominal 2019 GDP: (10 million apples) × ($2.00 / apple) = $20 million
• Nominal 2020 GDP: (12 million apples) x ($2.50/apple) = $30 million
• Real 2020 GDP (2019 base year): (12 million apples) × ($2.00 / apple) = $24 million
What was Appleville’s nominal GDP growth in 2020?
𝐺𝐷𝑃 𝑖𝑛 2020
𝐺𝐷𝑃 𝑖𝑛 2019
𝐺𝐷𝑃 𝑖𝑛 2019
$30 𝑚𝑖𝑙.
$20 𝑚𝑖𝑙.
$20 𝑚𝑖𝑙.
What was Appleville’s real GDP growth in 2020 (2019 base year):
50%
GDP Growth in Appleville
• Nominal 2019 GDP: (10 million apples) × ($2.00 / apple) = $20 million
• Nominal 2020 GDP: (12 million apples) x ($2.50/apple) = $30 million
• Real 2020 GDP (2019 base year): (12 million apples) × ($2.00 / apple) = $24 million
What was Appleville’s nominal GDP growth in 2020?
𝐺𝐷𝑃 𝑖𝑛 2020
𝐺𝐷𝑃 𝑖𝑛 2019
𝐺𝐷𝑃 𝑖𝑛 2019
$30 𝑚𝑖𝑙.
$20 𝑚𝑖𝑙.
$20 𝑚𝑖𝑙.
What was Appleville’s real GDP growth in 2020 (2019 base year):
$24 𝑚𝑖𝑙.
$20 𝑚𝑖𝑙.
$20 𝑚𝑖𝑙.
20%
50%
Real vs. Nominal
• “Real” GDP growth tells us how much production has really increased
• “Real” ~ Adjusted for inflation  Important not just for GDP!
• Median U.S. Household Income (Data Source: FRED)
• Nominal:
1990: $29.9k
2019: $68.7k  Growth: +130%
Real vs. Nominal
• “Real” GDP growth tells us how much production has really increased
• “Real” ~ Adjusted for inflation  Important not just for GDP!
•
Median U.S. Household Income: (Data Source: FRED)
• Nominal:
1990: $29.9k
2019: $68.7k  Growth: +130%
• Real (2019 base): 1990: $57.0k
2019: $68.7k  Growth: +20.5%
• If we hold prices constant, the real income (purchasing power) of households has
increased only 20.5% over the past 30 years and not 130%!
Real vs. Nominal
• “Real” GDP growth tells us how much production has really increased
• “Real” ~ Adjusted for inflation  Important not just for GDP!
•
Preview example: Your income!
•
Imagine you started a job in 2021 that pays $20/hour.
•
Imagine that, in 2022, your boss offers you a 5% raise.
•
Also assume that, between 2021 and 2022, inflation was 8%.


Nominal salary increase:…
Real salary increase:…
Real vs. Nominal
• “Real” GDP growth tells us how much production has really increased
• “Real” ~ Adjusted for inflation  Important not just for GDP!
•
Preview example: Your income!
•
Imagine you started a job in 2021 that pays $20/hour.
•
Imagine that, in 2022, your boss offers you a 5% raise.
•
Also assume that, between 2021 and 2022, inflation was 8%.



Nominal salary increase: 5%
Real salary increase: ‐3% !
You actually have lower purchasing power now because your salary has not kept up with inflation!
Real vs. Nominal
McDonalds prices in 1970s (source unclear)
Pan Am ad from 1960s
Price Changes
• So far we asked: How much has aggregate production (quantities) really changed?
• We can also ask: How much have prices changed at the aggregate level?
Price Changes
• So far we asked: How much has aggregate production (quantities) really changed?
• We can also ask: How much have prices changed at the aggregate level?
• In Appleville this is obvious since there is only one good and thus price:
•
Nominal 2019 GDP: (10 million apples) × ($2.00 / apple) = $20 million
•
Nominal 2020 GDP: (12 million apples) x ($2.50/apple) = $30 million
 Apple prices increased $0.50 = 25%
Price Changes
• So far we asked: How much has aggregate production (quantities) really changed?
• We can also ask: How much have prices changed at the aggregate level?
• But what about a more complicated economy where:
• 2019 Nominal GDP: 𝑄
·𝑃
)+ 𝑄
·𝑃
𝑄
·𝑃
)+…
• 2020 Nominal GDP: 𝑄
·𝑃
)+ 𝑄
·𝑃
𝑄
·𝑃
)+…
• How can we measure overall price changes?
Price Changes: (1) GDP Deflator
GDP Deflator =
· 100
• Measures how prices of goods and services produced in a country have risen since the base year
• Note: GDP Deflator and other price indexes are always = 100 in the (arbitrarily chosen) base year
Price Changes: (1) GDP Deflator
· 100
GDP Deflator =
• Measures how prices of goods and services produced in a country have risen since the base year
• Let’s make sure this works in our Appleville example using 2019 as base year:
GDP Deflator_2019 =
….
….
...
…
· 100
GDP Deflator_2020 = · 100
…
⋯
Price Changes: (1) GDP Deflator
· 100
GDP Deflator =
• Measures how prices of goods and services produced in a country have risen since the base year
• Let’s make sure this works in our Appleville example using 2019 as base year:
GDP Deflator_2019 =
$
$
.
.
...
…
· 100
GDP Deflator_2020 = · 100
100
⋯
Price Changes: (1) GDP Deflator
· 100
GDP Deflator =
• Measures how prices of goods and services produced in a country have risen since the base year
• Let’s make sure this works in our Appleville example using 2019 as base year:
GDP Deflator_2019 =
$
$
.
.
· 100
100
GDP Deflator_2020 =
$
$
.
.
· 100
125
Price Changes: (1) GDP Deflator
· 100
GDP Deflator =
•
Measures how prices of goods and services produced in a country have risen since the base year
• Let’s make sure this works in our Appleville example using 2019 as base year:
GDP Deflator_2019 =
$
$
.
.
· 100
100
GDP Deflator_2020 =
$
$
.
.
· 100
125
 Between 2019 and 2020, overall prices in Appleville have risen:
Percent change in GDP deflator =
25%
√ Matches 25% apple price increase
Price Changes: (2) Consumer Price Index
• The Consumer Price Index (CPI) measures the cost of buying a basket of goods and
services in the current year divided by the cost of the same basket in the base year
CPI =
∙100
• Why do we need this? Why don’t we just use the GDP deflator?
Price Changes: (2) Consumer Price Index
• The Consumer Price Index (CPI) measures the cost of buying a basket of goods and
services in the current year divided by the cost of the same basket in the base year
CPI =
∙100
• Why do we need this? Why don’t we just use the GDP deflator?
• CPI (ideally) measures cost of living for households
• Remember GDP Deflator includes everything produced in the economy – missiles,
conveyor belts, hay, MRI machines, etc. CPI focuses on things bought by households.
• Households also buy things not counted in GDP, e.g., imported electronics
Price Changes: (2) Consumer Price Index*
• Why is this important?
• CPI and how it is measured affects many policies and peoples’ lives!
• E.g.: Many income support programs include cost‐of‐living adjustments (COLA)
Source: AARP
Price Changes: (2) Consumer Price Index*
• How is this actually done?
• U.S. Bureau of Labor Statistics (BLS) uses Consumer Expenditure Survey to figure out
typical basket of goods and services
•
Based on ~20,000+ interviews and 10,000+ purchase diaries per year done by Census Bureau
• Consider prices for more than 7,000 goods and services across different cities
• BLS data collectors record prices of about 80,000 items each month (in person at
store, online, on phone, etc.)
• Census also conducts surveys of “Point‐of‐Purchase” – where do people buy stuff? –
to figure out which stores or outlets’ prices are most relevant for consumers
Price Changes: (2) Consumer Price Index*
• Examples of Challenges:
1) Different populations consume different baskets
• BLS computes some differentiated CPI measures, e.g.:
•
CPI‐U focuses on all urban consumers representing 93% of US population
•
CPI‐W focuses on urban Wage Earners and Clerical Workers
•
Experimental CPI‐E focuses on ages 62+

Higher weight on, e.g., medical spending

Should Social Security COLA adjustments use CPI‐E?
Price Changes: (2) Consumer Price Index*
New research by Xavier Jaravel (2017) also
raises concerns about inflation inequality
as low‐ and high‐income consumers
buy different baskets:
Price Changes: (2) Consumer Price Index*
In the news: Different groups
consume different bundles and
experience different levels of
inflation
Wall Street Journal, March 17,
2022
Price Changes: (2) Consumer Price Index*
• Examples of Challenges:
2) Accounting for product quality changes
“Cell phone” year 2000
“Cell phone” year 2020
Price Changes: (2) Consumer Price Index*
• Examples of Challenges:
2) Accounting for product quality changes
• In the news: Some companies are
deliberately changing their product
quality to either help justify price
increases (e.g., Coach purses) or reduce
costs (e.g., Macy’s sofas) (WSJ, March
2022)
Inflation
• Inflation: Rate of increase in prices
• Different precise measures, e.g., year‐over‐year percent change in a price index
• Example using the CPI:
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
𝐶𝑃𝐼
𝐶𝑃𝐼
𝐶𝑃𝐼
What is the rate of inflation implied by the year‐over‐year change in the CPI as of February 2022?
=
 7.9% inflation
.
.
.
=0.079
Inflation: Data
Real vs. Nominal
• Finally, price indexes (like the CPI) allow us to compare the value of things over time
Value of Year XXXX amount in YYYY =
· 𝑉𝑎𝑙𝑢𝑒 𝑖𝑛 𝑋𝑋𝑋𝑋
Real vs. Nominal
• Finally, price indexes (like the CPI) allow us to compare the value of things over time
Value of Year XXXX amount in YYYY =
· 𝑉𝑎𝑙𝑢𝑒 𝑖𝑛 𝑋𝑋𝑋𝑋
• What year was the minimum wage the highest? (Hint: It’s not 2016!)
Real vs. Nominal
· 𝑉𝑎𝑙𝑢𝑒 𝑖𝑛 𝑋𝑋𝑋𝑋
Value of Year XXXX amount in YYYY =
• Value of Year 1956 minimum wage in 2016 =
.
.
· $1.00 = $8.81
Real vs. Nominal
· 𝑉𝑎𝑙𝑢𝑒 𝑖𝑛 𝑋𝑋𝑋𝑋
Value of Year XXXX amount in YYYY =
• Value of Year 1956 minimum wage in 2016 =
.
.
• Etc., until: Value of 1967 amount in 2016 dollars =
· $1.00 = $8.81
.
.
· $1.40 = $10.03
Real vs. Nominal
• Finally, price indexes (like the CPI) allow us to compare the value of things over time
Value of Year XXXX amount in YYYY =
· 𝑉𝑎𝑙𝑢𝑒 𝑖𝑛 𝑋𝑋𝑋𝑋
• What year was the minimum wage the highest? (Hint: It’s not 2016!)
Value of 1967 amount in
.
· $1.40
2016 dollars =
.
= $10.03