ECONOMICS
What Does It Mean To Me?
Unit 2: MEASURING THE
MACROECONOMY
•Business Cycle
•Unemployment
•GDP Equation (nominal/real)
•Marginal Propensity to Consume/Save
•Price Deflator
•CPI
READ: Krugman
Chapters 23, 24
OR Mankiw, Chapters
23, 24, 28
OR, here’s an idea!!
READ THEM ALL!!
Websites for government agencies that collect
economic data:
Bureau of Labor Statistics
Federal Reserve
www.bls.gov
www.federalreserve.gov
Congressional Budget Office
Department of Commerce
www.cbo.gov
www.commerce.gov
You have a handout for collecting
economic data. It’s due tomorrow.
*Mankiw
Ten Propositions about Which Most
Economists Agree
*Mankiw
BUSINESS CYCLE
The Business Cycle is the short-run alternation
between economic downturns and economic upturns.
Depression is a very deep and prolonged downturn.
(over 3 reporting periods)
Recessions are periods of economic downturns when
output and employment are falling. (2 reporting periods)
Expansions, sometimes called recoveries, are periods
of economic upturns when output and employment are
rising.
*Krugman
The Circular-Flow Diagram
Revenue
Goods
and services
sold
MARKETS
FOR
FACTORS OF PRODUCTION
•Households sell
•Firms buy
FIRMS
•Produce and sell
goods and services
•Hire and use factors
of production
Factors of
production
Wages, rent,
and profit
Spending
Goods and
services
bought
HOUSEHOLDS
•Buy and consume
goods and services
•Own and sell factors
of production
MARKETS
FOR
GOODS AND SERVICES
•Firms sell
•Households buy
Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of dollars
*Mankiw
Copyright © 2004 South-Western
An Expanded Circular-Flow Diagram: The
Flows of Money Through the Economy
*Krugman
QUESTIONS TO ANSWER:
What happens during a business cycle, and
what can be done about it?
the effects of recessions and expansions on
unemployment;
the effects on aggregate output; and
the possible role of government policy.
Policy efforts undertaken to reduce the severity of
recessions are called stabilization policy.
One type of stabilization policy is monetary
policy, changes in the quantity of money or the
interest rate. (raise/lower interest rate, raise/lower
reserve requirement, buy/sell T-bills)
The second type of stabilization policy is fiscal
policy, changes in tax policy or government
spending, or both. (raise/lower taxes, raise/lower
spending)
*Krugman
Secular long-run growth, or long-run growth,
is the sustained upward trend in aggregate output
per person over several decades.
A country can achieve a permanent increase in the
standard of living of its citizens only through longrun growth. So a central concern of
macroeconomics is what determines long-run
growth.
*Krugman
UNEMPLOYMENT
How Is Unemployment Measured?
–Categories of Unemployment
•The problem of unemployment is usually
divided into two categories, the long-run
problem and the short-run problem.
•Natural rate of unemployment does not go
away on its own even in the long run.
•Cyclical rate of unemployment year-to-year
fluctuations in unemployment around its natural
rate.
*Mankiw
•Unemployment is measured by the Bureau of Labor
Statistics (BLS).
•It surveys 60,000 randomly selected households
every month.
•The survey is called the
Current Population Survey
•Based on the answers to the survey
questions, the BLS places each adult into one
of three categories:
**Employed
**Unemployed
**Not in the labor force
*Mankiw
Employment is the number of people working in the
economy.
Unemployment is the number of people who are
actively looking for work but aren’t currently employed.
The labor force is equal to the sum of employment
and unemployment.
*Krugman
•Employed vs. unemployed
–The BLS considers a person an adult if he or she is
over 16 years old.
–A person is considered employed if he or she has
spent some of the previous week working at a paid
job.
–A person is unemployed if he or she is on temporary
layoff, is looking for a job, or is waiting for the start
date of a new job.
–A person who fits neither of these categories, such
as a full-time student, homemaker, or retiree, is not in
the labor force.
*Mankiw
Employed
(139.3 million)
Labor Force
(147.4 million)
Adult
Population
(223.4 million)
Unemployed (8.1 million)
Not in labor force
(76.0 million)
*Mankiw
Discouraged workers are non-working people who are
capable of working but are not actively looking for a job.
They would like to work but have given up looking for jobs
after an unsuccessful search, don’t show up in
unemployment statistics.
Underemployment is the number of people who work
during a recession but receive lower wages than they would
during an expansion due to smaller number of hours
worked, lower-paying jobs, or both.
The unemployment rate is the ratio of the number of
people unemployed to the total number of people in the
labor force, either currently working
*Krugman
History of the unemployment rate since 1948
*Krugman
• The unemployment rate is calculated as
the percentage of the labor force that is
unemployed.
Number unemployed
Unemployment rate =
 100
Labor force
*Mankiw
• The labor-force participation rate is the
percentage of the adult population that is
in the labor force.
Labor Force Participation Rate
Labor force X
=
100
Adult population
*Mankiw
Percent of
Labor Force
10
Unemployment rate
8
6
Natural rate of
unemployment
4
2
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
*Mankiw
2005
Demographic Groups
*Mankiw
Labor-Force
Participation
Rate (in percent)
1950
100
80
Men
60
40
Women
20
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
*Mankiw
*Mankiw
Why Are There Always Some People
Unemployed?
• In an ideal labor market, wages would adjust to balance the
supply and demand for labor, ensuring that all workers
would be fully employed.
Labor Supply
Wage
WE
Labor Demand
QE
Quantity of labor
*Mankiw
•Frictional unemployment refers to the
unemployment that results from the time that
it takes to match workers with jobs.
–In other words, it takes time for workers to
search for the jobs that are best suit their tastes
and skills.
•Structural unemployment is the
unemployment that results because the
number of jobs available in some labor
markets is insufficient to provide a job for
everyone who wants one.
*Mankiw
•Unemployment insurance is a
government program that partially protects
workers’ incomes when they become
unemployed.
*Mankiw
•Structural unemployment occurs when the
quantity of labor supplied exceeds the
quantity demanded.
•Structural unemployment is often thought to
explain longer spells of unemployment.
•Why is there Structural Unemployment?
–Minimum-wage laws
–Unions
–Efficiency wages
•When the minimum wage is set above the
level that balances supply and demand, it
creates unemployment.
*Mankiw
Unemployment from a Wage Above the Equilibrium
Level
Wage
Labor
supply
Surplus of labor =
Unemployment
Minimum
wage
WE
Labor
demand
0
LD
LE
LS
Quantity of
Labor
*Mankiw
•A union is a worker association that bargains with
employers over wages, benefits and working conditions.
•In the 1940s and 1950s, when unions were at their peak,
about a third of the U.S. labor force was unionized.
•A union is a type of cartel attempting to exert its market
power.
•The process by which unions and firms agree on the terms of
employment is called collective bargaining.
•A strike will be organized if the union and the firm cannot reach
an agreement.
–A strike occurs when the union organizes a withdrawal of
labor from the firm.
•A strike makes some workers better off and other workers
worse off.
•Workers in unions (insiders) reap the benefits of collective
bargaining, while workers not in the union (outsiders) bear
some of the costs.
•By acting as a cartel with ability to strike or otherwise
impose high costs on employers, unions usually achieve
above-equilibrium wages for their members.
•Union workers earn 10 to 20 percent more than nonunion
workers.
•Critics argue that unions cause the allocation of labor to be
inefficient and inequitable.
•Wages above the competitive level reduce the quantity of
labor demanded and cause unemployment.
•Some workers benefit at the expense of other workers.
•Efficiency wages are above-equilibrium wages paid by firms
in order to increase worker productivity.
•A firm may prefer higher than equilibrium wages for the
following reasons:
–Worker health: Better paid workers eat a better diet and
thus are more productive.
–Worker turnover: A higher paid worker is less likely to
look for another job.
–Worker quality: Higher wages attract a better pool of
workers to apply for jobs.
–Worker effort: Higher wages motivate workers to put
forward their best effort.
Unemployment Rate
*Krugman
GROSS DOMESTIC
PRODUCT
GROSS DOMESTIC PRODUCT is defined
as:
The market value of all final goods and
services produced within a country in a
given period of time. It does NOT include
the value of intermediate goods.
Intermediate goods and services are
inputs for production of final goods and
services, such as the purchase of glass or
steel to build an automobile
*Krugman
GDP can be calculated in one of 3 ways:
1) Measuring GDP as the Value of
Production of Final Goods and Services.
2) Measuring GDP as Spending on
Domestically Produced Final Goods and
Services.
3) Measuring GDP as Factor Income
Earned from Firms in the Economy.
Calculating GDP
2
3
1
3 ways to
calculate
GDP
*Krugman
U.S. GDP in 2004: Two Methods of Calculating GDP
*Krugman
The four major components or
determinants of Gross Domestic Product
are:
•Consumption (C)
•Investment (I)
•Government Spending (G)
•Net Exports (X-M)
GDP (Y) is equal to:
C + I + G + (X - M)
GDP and Its Components (2001)
Government Purchases
18%
Net Exports
Investment
-3
%
16%
Consumption
69%
The most important factor in aggregate
demand is
CONSUMPTION (C)
Therefore, understanding consumption is
of vital importance, as it will eventually
affect total output and income.
Is it true that the higher the
national income, the more it
spends on consumer items?
The answer is YES.
However, it is also true that what matters most
is not the total income but the after-tax income
called DISPOSABLE INCOME.
Milton Friedman,
economist, observed that
consumption is related to
permanent income rather
than current income
levels. This is called the
PERMANENT INCOME
HYPOTHESIS.
For example, it has been shown that college students and very
old persons tend to spend more than their total income. These
groups DISSAVE.
On the other hand, people in their 30s and 40s tend to save
quite a bit and consume relatively less of their income.
WHY IS THIS?
College students expect to make the bulk of their
earnings after graduation and, thusly, base
consumption on future earnings.
Middle age persons expect to retire
in the future and tend to save for
that eventuality.
Older people expect to die in the future and feel
withdrawal of their savings is justified.
Additionally, the consumption rate
may be based on occupation.
Farmers have “good” years and
“bad” years. They save more in
the good years to maintain
consumption in the bad years.
A professional football player may
save more and consume less during
his playing years because he knows
that his professional life is limited.
WHAT IS THE AVERAGE
AND MARGINAL
PROPENSITY TO
CONSUME?
Households will generally spend the majority of their
total income and save the remainder.
The portion of total income consumed is
called the AVERAGE PROPENSITY TO
CONSUME (APC).
(i.e.) If a family spends $1350 out of
$1500 total income, it has an APC of 0.9
(1350/1500).
So, how would an increase in income
affect the consumption of this family?
That depends on the MARGINAL
PROPENSITY TO CONSUME (MPC).
MPC is the additional consumption that
results from an additional dollar of
disposable income.
If consumption goes from $1350 to $1800
while disposable income goes from $1500 to
$2100, what is the MPC?
Firstly, calculate change ( ) in consumption:
1800 - 1350 = 450
Secondly, calculate change ( ) in income:
2100 - 1500 = 600
MPC = consumption/disposable income
450/600 = 3/4 = 0.75
We interpret this by
saying
…..for each additional
dollar in after-tax
income, this family will
consume an additional
0.75 or 75 cents.
Examples of changes in
CONSUMPTION (C) might
include:
•Increase/decrease in consumer
confidence or consumer expectations
of the future. (i.e. raise in salary)
•Increase/decrease in wealth. (i.e.
land, stocks, homes)
•Increase/decrease in taxes.
•Increase/decrease in population.
•Increase/decrease in savings or
debt.
The next determinant in determining
aggregate demand is:
INVESTMENT (I)
Investment expenditures are an important
part of aggregate demand, as well as
GDP; therefore, changes in investment
spending will also be responsible for
changes in the level of economic activity.
If you will recall, spending on
investments is the most unstable portion
of GDP because of its sensitivity to
changes in political, social, and
economic conditions…..
First, we need to determine the
difference between INDUCED
INVESTMENT and AUTONOMOUS
INVESTMENT.
INDUCED INVESTMENT occurs when good
business climate “induces” firms to invest, as
an increasing growth in future demand is likely.
The elements which impact Induced
Investment include:
OPTIMISM:
Investment is greater when people are
more optimistic.
LEVEL OF AND RATE OF CHANGE in
PROFITS: When economic growth is high,profits
are high and rising. If total revenue is high, the
resulting profit enables businesses to invest more.
AUTONOMOUS INVESTMENT is investment
that is not determined by the level of income.
The elements which impact
Autonomous Investment include:
INTEREST RATES: The higher the interest rate, the
higher the opportunity cost in capital; fewer investments will
now have benefits greater than the new higher costs.
RATE of CAPITAL UTILIZATION: When output is relative
to the ability of business capital to produce goods, capital
utilization rates are also low, and new investment will be lower.
INVENTORIES: High inventories occur when sales are
less than expected.. Inventory investment will be high,
causing a reduction in planned investment.
Examples of changes in
INVESTMENT (I) might
include:
•Increase/decrease in interest
rates.
•Increase/decrease in business
confidence or expected returns on
investment projects.
•Increase/decrease in business
taxes.
•New and improved technology will
stimulate investment.
•Degree in excess capacity
(unused existing capital) will retard
demand for new capital goods and
reduce aggregate demand.
A third determinant of aggregate demand is:
GOVERNMENT
SPENDING (G)
Government spending can vary over time for a variety
of reasons. While volatile shifts may occur at the
beginning or end of wars, for example, the tendency
is that spending will increase with rising income
because of the decrease in welfare payments and
unemployment compensation.
An increase in
GOVERNMENT
SPENDING (G)
would also shift the
aggregate demand
curve to the right,
while a decrease in
spending would
shift the curve to
the left.
An example would be
a decision by
government to
expand the interstate
highway system. In
contrast, a reduction
in spending, such as
a cutback in orders
for the military, will
reduce aggregate
demand.
The fourth determinant of aggregate
demand is:
NET EXPORTS
(X - M)
The impact of international trade effects has become
increasingly important. Exports (X) must be added to
the demand side of the equation to realize the effect
of foreign buyers on our economy. Additionally,
Import (M) must be subtracted from the equation to
realize purchases made which have no direct impact
on our economy.
Exports minus imports (X - M) is what we
call NET EXPORTS.
It represents BALANCE OF TRADE.
A higher level of U.S. exports constitutes an
increased foreign demand for U.S. goods.
A reduction of U.S. imports implies an
increased domestic demand for U.S.produced products.
Positive net exports (X - M), as a result of
greater demand for U.S. goods will create a
higher level of aggregate demand.
This might explain why a country in a
recession might like to run a trade
surplus by increasing exports.
The non-price-level factors which alter net exports
are primarily NATIONAL INCOME ABROAD and
EXCHANGE RATES.
NATIONAL INCOME ABROAD
Rising national income in a foreign nation
increases the foreign demand for U.S. goods,
increasing aggregate demand in the United
States.
Declines in national income abroad have the
opposite effect: U.S. net exports decline,
shifting the U.S. aggregate demand curve
leftward.
EXCHANGE RATES
A change in the exchange rate between the dollar and other
currencies also affects net exports and hence aggregate
demand.
Suppose the dollar price of yen rises, meaning the dollar
depreciates in terms of the yen. This is the same as saying
the yen price of dollar falls--the yen appreciates.
The new relative values of dollars and yen means consumers
in Japan can obtain more dollars with any particular number of
yen. Consumers in the U.S. can obtain fewer yen for each
dollar.
Japanese consumers therefore discover that U.S. goods are
cheaper in terms of yen……they buy more U.S. goods.
Consumers in the U.S. find that fewer Japanese products can
be purchased with a set number of dollars…..they buy fewer
Japanese goods.
With respect the U.S. exports, a $30
pair of U.S.-made blue jeans now
might be brought for 2880 yen
compared to 3600 yen. In terms of
U.S. imports, a Japanese watch might
now cost $225 rather than $180.
Under these circumstances, U.S. exports will
rise and imports will fall. This increase in NET
EXPORTS translates into a rightward shift in
U.S. aggregate demand.
A closed economy is an economy that does not
trade goods, services, and assets.
The United States has become increasingly open, so
that open-economy macroeconomics has become
increasingly important.
Open-economy macroeconomics is the study of
those aspects of macroeconomics that are affected by
movements of goods, services, and assets across
national boundaries.
*Krugman
One of the main concerns introduced by open-economy
macroeconomics is the exchange rate, the price of one
currency in terms of another.
Exchange rates can affect the aggregate price level.
They can also affect aggregate output through their
effect on the trade balance, the difference between
the value of the goods and services a country sells to
other countries and the value of the goods and
services it buys in return.
Economists are also concerned about capital flows,
movements of financial assets across borders.
*Krugman
Movements of the exchange rate between the
U.S. dollar and the euro
*Krugman
Examples of changes in NET EXPORTS
(X - M) might include:
•When major trading partners are experiencing economic
slowdowns, causing the demand for exports to fall, shifting the
curve to the left.
•When major trading partners are experiencing economic
booms, causing the demand for exports to rise, shifting the
curve to the right.
The Consumer
Confidence Survey
measures the level of
confidence individual
households have in the
performance of the
economy.
Questionnaires are
sent to 5,000
households; about
3,500 are returned.
The five questions include:
•A rating of current business conditions in
the household’s area.
•Rating of expected business conditions in
six months.
•Current job availability in the area.
•Expected job availability in six months.
•Expected family income in six months.
The results are compiled into indexes for the
present and expected future economic situations.
The Consumer Confidence index has the
potential to reflect important aggregate
demand shifters.
•Will expected stock market wealth increase
their spending?
•Will inflation on the horizon increase saving?
•Will expected joblessness decrease spending?
We can conclude, therefore, the
PERCEPTIONS of consumers and
businesses on the state of the economy
are important aggregate demand shifters
and can have a significant impact on
price level, real output, and employment.
NOMINAL GDP vs.
REAL GDP
Real GDP: the value of the final goods and
services produced calculated using the prices of
some base year.
Nominal GDP: output valued at current prices.
Real GDP per capita is a measure of average
output per person, but is not by itself an
appropriate policy goal.
*Krugman
REAL VERSUS NOMINAL GDP
Nominal GDP
values the production of goods and services
at current prices.
Real GDP
values the production of goods and services
at constant prices.
*Krugman
Real vs. Nominal GDP
*Krugman
Real vs. Nominal GDP
*Krugman
The Relationship between Real GDP and
Unemployment, 1949-2004
*Krugman
To calculate REAL GDP, we must choose
a base year.
The current base year used for federal
statistics is 2001.Therefore 2001 prices
are used to calculate REAL GDP.
Because REAL GDP uses a constant
base year, changes in REAL GDP
measure only the amounts being
produced.
In the year 2001, the economy produces 100 loaves of bread
that sell for $2 each. In the year 2002, the economy produces
200 loaves of bread that sell for $3 each. Calculate nominal
GDP, real GDP and the GDP price deflator for each year. (use
2001 as the base year) by what percentage does each of
these three statistics rise from one year to the next?
Year 2001
100 x $2 = 200
nominal GDP
100 x $2 = 200
real GDP
($200/$200) x 100 = 100 GDP deflator
Year 2002
200 x $3 = 600
nominal GDP
200 x $2 = $400real GDP
($600/$400) x 100 = 150 GDP deflator
In the year 2001, the economy produces 100 loaves of bread that sell for
$2 each. In the year 2002, the economy produces 200 loaves of bread
that sell for $3 each. Calculate nominal GDP, real GDP and the GDP price
deflator for each year. (use 2001 as the base year) By what
percentage does each of these three statistics rise from
one year to the next?
Year 2001
Year 2002
100 x $2 = 200
nominal GDP
100 x $2 = 200
real GDP
($200/$200) x 100 = 100 GDP deflator
200 x $3 = 600
nominal GDP
200 x $2 = $400real GDP
($600/$400) x 100 = 150 GDP deflator
Percentage change in nominal GDP is (600 - 200)/200 x 100 = 200%
Percentage change in real GDP is (400 - 200)/200 x 100 = 100%
Percentage change in the deflator is (150 - 100/100 x 100 = 50%
• You borrowed $1,000 for one year.
• Nominal interest rate was 15%.
• During the year inflation was 10%.
Real interest rate = Nominal interest rate –
Inflation
= 15% - 10% = 5%
The GDP Price Deflator measures the
current level of prices relative to the level of
prices in the base year.
Nominal GDP
GDP DEFLATOR =
Real GDP
X 100
Calculating GDP and Real GDP in a Simple
Economy
What is the total value of sales in the 1st
year?
(2000b x .25) + (1000b x .50) = $1000b
What is the total value of sales in the 2nd
year?
(2200b x .30) + (1200b x .70) = $1500b
Although
the
So
Notice
part of the 50%
increase
quantities
of both
the
in the
2nddollar value
of GDP
apples and oranges
simply
year isreflects
higher prices,
increased the prices
not
50%higher production
of both applesofand
larger. output.
oranges also rose.
*Krugman
Calculating GDP and Real GDP in a Simple
Economy
What is the total value of sales in the 1st
year?
(2000b x .25) + (1000b x .50) = $1000b
What is the total value of sales in the 2nd
year?
(2200b x .25)
.30) + (1200b x .50)
.70) = $1150B
$1500b
So, how much would GDP have
gone up if price had NOT changed?
To do this, simply calculate Q at
year 1 prices.
*Krugman
Now, we can define REAL GDP as the
total value of final goods and
services produced in the economy
during a year, calculated as if prices
had stayed constant at the level of
some given base year.
*Krugman
U.S. real gross domestic product per
person from 1900 to 2004
*Krugman
INFLATION and the
Consumer Price Index
(CPI)
The aggregate price level is the overall level of prices in the
economy.
A rising aggregate price level is inflation.
A falling aggregate price level is deflation.
The inflation rate is the annual percent change in the
aggregate price level.
The economy has price stability when the aggregate
price level is changing only slowly.
*Krugman
Inflation and deflation since 1929
*Krugman
Consumer price index from 1913 to 2004
*Krugman
INFLATION: when the economy’s overall price
level is rising.
INFLATION RATE: percentage change in the
price level from the previous period
CPI -- prime indicator of inflation and
recession
• Comprised of a market basket of
goods and services.
• Measures current cost of living
against base year (2000)
Price Indexes and the Aggregate Price Level
A price index is the ratio of the current cost of that market
basket to the cost in a base year, multiplied by 100.
*Krugman
Calculating the Cost of a Market Basket
Suppose a frost in Florida destroys most of the citrus crop. As a result, the
price of oranges go from $.20 to $.40 and the price of grapefruit rises from
$.60 to $1.00 and lemons rise from $.25 to $.45.
We could recite three prices OR calculate an overall measure of the
AVERAGE price increase.
Economists measure average price changes by comparing a consumer’s
consumption bundle from year to year. This is also called the
MARKET BASKET.
*Krugman
Calculating the Cost of a Market Basket
In the example above, the MARKET BASKET cost $95 before the frost.
After the frost, it cost $175.
Since 175/95 = 1.842, the post-frost basket costs 1.842 times the cost of
the pre-frost basket, an increase of 84.2%.
In this case, we would say that the average price of citrus fruit increased
84.2% as a result of the frost.
*Krugman
The Makeup of the Consumer Price Index in
2004
*Krugman
FYI: What’s in the CPI’s Basket?
16%
Food and
beverages
17%
Transportation
Education and
communication
41%
Housing
6%
6%
6% 4% 4%
Medical care
Recreation
Apparel
Other goods
and services
Copyright©2004 South-Western
The CPI, the PPI, and the GDP Deflator
*Krugman
Problems in Measuring the Cost of Living
Substitution bias
*Consumers substitute toward goods that have become relatively less expensive.
*The index overstates the increase in cost of living by not considering consumer
substitution
Introduction of new goods
*New products result in greater variety, which in turn makes each dollar more valuable.
*Consumers need fewer dollars to maintain any given standard of living.
Unmeasured quality changes
*If the quality of a good rises from one year to the next, the value of a dollar
rises, even if the price of the good stays the same.
*If the quality of a good falls from one year to the next, the value of a dollar falls,
even if the price of the good stays the same.
*The BLS tries to adjust the price for constant quality, but such differences are
hard to measure.
When the CPI rises, a family will have to
spend more money to make the same
purchases.
To calculate CPI:
1) Choose what goes into your market
basket. The Bureau of Labor Statistics
conducts surveys to determine the
consumption of the typical consumer.
For example: 2 pizzas,3 sodas
To calculate CPI:
2)Determine the prices of the market basket
for each point in time.
Year
PricePizza(2)
PriceSoda(3)
2001
$5
$1
2002
$8
$2
2003
$10
$3
To calculate CPI:
3)Determine the total cost of the market
basket.
Year
PricePizza(2)
PriceSoda(3)
2001
$5
$1
2002
$8
$2
2003
$10
$3
2001: (2x5) + (3x1) = $13
2002: (2x8) + (3x2) = $22
2003: (2x10) + (3x3) = $29
To calculate CPI:
4)Select a base year and compute the CPI in
each year
2001: (2x5) + (3x1) = $13
2002: (2x8) + (3x2) = $22
2003: (2x10) + (3x3) = $29
2001: (13/13) x 100 = 100
2002: (22/13) x 100 = 169
2003: (29/13) x 100 = 223
To calculate CPI:
5)Compute the Inflation Rate.
CPI:yr2 - CPI:yr1
IR:yr2 =
CPI:yr1
x 100
2001: (13/13) x 100 = 100
2002: (22/13) x 100 = 169
2003: (29/13) x 100 = 223
2002: (169-100)/100 x 100 = 69%
2003: (223-169)/169 x 100 = 32%
The CPI is used to calculate
how prices have changed over
the years.
Let’s say you have $7 in your
pocket to purchase some goods
and services today. How much
money would you have needed in
1950 to buy the same amount of
goods and services?
The CPI for 1950 = 24.1
The CPI for 1999 (based on first 5 months of
1999 = 166.2
Use the following formula to compute the
calculation:
1950 price = 1999 Price * (1950 CPI / 1999
CPI)
THE ANSWER:
$7.00 * 24.1 / 166.2 = $1.02
Let’s say your parents told you
that in 1950 a movie cost 25
cents. How could you tell if
movies have increased in
price faster or slower than
most goods and services? To
convert that price into today’s
dollars, use the CPI.
The CPI for 1950 = 24.1
The CPI for 1999 (based on first 5
months of 1999 = 166.2
Use the following formula to
compute the calculation:
1999 price = 1950 Price * (1999 CPI /
1950 CPI)
THE ANSWER:
$0.25 * 166.2 / 24.1 = $1.72
In 1999, a full priced movie
in South Florida cost
between $5.00 and $7.00. It
looks like movies have
increased in price faster
than most other goods and
services.
• Do the following to convert (inflate) Babe
Ruth’s wages in 1931 to dollars in 2001:
Salary2001
Price level in 2001
= Salary1931 
Price level in 1931
177
= $80,000 
15.2
= $931,579
Two Measures of Inflation
Percent
per Year
15
CPI
10
5
0
GDP deflator
1965
1970
1975
1980
1985
1990
1995
2000
Copyright©2004 South-Western
QUESTIONS FOR
REVIEW
Two goods are produced: hot dogs and hamburgers:
Price
Quantity
Price
Quantity
Year
Hot Dogs
Hot Dogs
Hamburgers
Hamburgers
2005
$1
100
$2
50
2006
$2
150
$3
100
2007
$3
200
$4
150
What is the NOMINAL GDP for each year?
Nominal GDP for 2005 = ($1 x100) + ($2 x50) = $200
Nominal GDP for 2006 = ($2 x150) + ($3 x100) = $600
Nominal GDP for 2007 = ($3 x200) + ($4 x150) = $1,200
Two goods are produced: hot dogs and hamburgers:
Price
Quantity
Price
Quantity
Year
Hot Dogs
Hot Dogs
Hamburgers
Hamburgers
2005
$1
100
$2
50
2006
$2
150
$3
100
2007
$3
200
$4
150
What is the REAL GDP for each year
assuming a base year of 2005?
Real GDP for 2005 = ($1 x100) + ($2 x50) = $200
Real GDP for 2006 = ($1 x150) + ($2 x100) = $350
Real GDP for 2007 = ($1 x 200) + ($2 x150) = $500
The country of Coltsville produces two goods: footballs and
basketballs.
Price
Quantity
Price
Quantity
Year
Footballs
Footballs
Basketballs
Basketballs
Year 1
$10
120
$12
200
Year 2
$12
200
$15
300
Year 3
$14
180
$18
275
What is the nominal GDP for each year?
Nominal GDP for year 1 = ($10 x120) + ($12 x200) = $3,600
Nominal GDP for year 2 = ($12 x200) + ($15 x300) = $6,900
Nominal GDP for year 3 = ($14 x 180) + ($18 x275) = $7,470
The country of Coltsville produces two goods: footballs and
basketballs.
Price
Quantity
Price
Quantity
Year
Footballs
Footballs
Basketballs
Basketballs
Year 1
$10
120
$12
200
Year 2
$12
200
$15
300
Year 3
$14
180
$18
275
What is the real GDP for each year using
year 1 as the base year?
Real GDP for year 1 = ($10 x120) + ($12 x200) = $3,600
Real GDP for year 2 = ($10 x200) + ($12 x300) = $5,600
Real GDP for year 3 = ($10 x 180) + ($12 x275) = $5,100
NOTE that nominal GDP rises from Year 2 to Year 3, but real GDP falls.
The country of Coltsville produces two goods: footballs and
basketballs.
Price
Quantity
Price
Quantity
Year
Footballs
Footballs
Basketballs
Basketballs
Year 1
$10
120
$12
200
Year 2
$12
200
$15
300
Year 3
$14
180
$18
275
What is the GDP deflator for each year?
GDP deflator for year 1 = (3600/3600) x 100 = 1 x 100
= 100
GDP deflator for year 2 = (6900/5600) x 100 = 1.2321 x 100
= 123.21
GDP deflator for year 3 = (7470/5100) x 100 = 1.4647 x 100
= 146.71
During 2009, the country of Meachotopia
recorded a GDP of $65b, interest payments of
$15b, imports of $13b, profits of $7b, exports
of $15b, and rent of $7b. This would mean
wages during 2009 in Meachotopia were:
$36b
65b -15b -7b - 7b =
In the US, consumer spending accounts
for what percentage of GDP?
70%
In the US, investment spending
accounts for what percentage of GDP?
16%
GDP tends to understate our economic
well being because it:
excludes the value of leisure
If real GDP rises while nominal GDP
falls, then prices on average have
fallen
GDP tends to understate our economic
well being because it:
excludes the value of leisure
If real GDP rises while nominal GDP
falls, then prices on average have
fallen
Compiled by:
Virginia H. Meachum, Economics Teacher
Coral Springs High School
Sources:
Principles, Problems, and Policies, by Campbell McConnell
& Stanley Brue
Exploring Economics, by Robert Sexton
Principles of Economics, by N. Gregory Mankiw
Economics, by Paul Krugman & Robin Wells
Notes by Florida Council on Economic Education and FAU
Center for Economic Education
Notes by Foundation for Teaching Economics