We measure GDP because we must know how much we are producing We can not add apples and computers… We must use dollars as the “common denominator” We can add dollars worth of apples + dollars worth of computers… Why is GDP measured in dollars?
GDP at current prices Nominal GDP • We multiply quantities purchased by the price at which they sold on that year. Example: For 2009 GDP, we use prices paid in 2009 . • Because we use prices of 2009to compute GDP for 2009, we say that we used “current” prices.
Real GDP • We have to use prices • We must eliminate the effect of changing prices. • To eliminate the effect of changing prices, we pretend that prices did not change.
GDP at constant prices Real GDP • For Real GDP, we multiply quantities purchased by the price at which they sold on the base year. Example: For 2009 GDP, we use prices prevailing in base year . • Because we use prices of base year to compute GDP for 2009, we say that we used “constant” prices.
Price Index A price index is a number that represents overall prices for a given period of time –say a year-.
The GDP Deflator • A price index calculated from nominal and real GDP. • Called “implicit” price deflator because it is the price implicit in the difference between real and nominal GDP.
By how much to INFLATE Real GDP to get Nominal GDP Quantity X Quantity Y Quantity Y Nominal GDP Quantity X Price X Price Y Quantity Z Price Z Quantity Z GDP Price Index Price Z Price X = Price Y Real GDP
Nominal GDP GDP Deflator = X 100 Real GDP The GDP Deflator Formula
X 100 (Deflator previous year) Inflation Rate (Deflator Year X) - (Deflator previous year)
Which offer is better? Colombia $535,000 Pesos Bolivia $647 Bolivianos Rent is $800,000 Rent is $200 What is important is NOT how much they pay you, but how much you CAN BUY with what they pay you
Which offer is better? Colombia $535,000 Pesos Bolivia $647 Bolivianos Rent is $800,000 Food is $300 Rent is $200 Food is $300,000 We need to put all prices into ONE single measure to be able to judge whether most prices are higher or lower Some things are more expensive, others are cheaper…
The Consumer Price Index CPI The CPI measures average change in retail prices over time for a basket of goods and services.
A Basket of Basic Necessities 28,000 diaries and 60,000 interviews Determine What and HowMany? 200 categories of goods and services divided into 8 groups and weighted by importance. FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals and snacks); HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture); APPAREL (men's shirts and sweaters, women's dresses, jewelry); TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance); MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services); RECREATION (televisions, cable television, pets and pet products, sports equipment, admissions); EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories); OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses). 2007-2008
Although not a “price” CPI includes • Some government-charged user fees: • Water and sewerage charges, auto registration fees, and vehicle tolls. • The CPI also includes taxes: • Such as sales and excise taxes that are directly associated with the prices of specific goods and services.
CPI Excludes • Taxes: • Such as income and Social Security taxes that are not directly associated with the purchase of consumer goods and services. • Prices of paper goods: • Such as stocks, bonds, real estate, and life insurance. Because these items relate to savings and not to day-to-day consumption expenses.
Relative Importance What is included in each category?
Calculating the CPI 1982-84
CPI= (Basket Cost current year / Basket Cost base year)*100 CPI= 200
One Basket = Half Basket =
Finding Real Values • To calculate the value of a dollar amount in base year prices (eliminating the effect of changing prices): • Real Value = (Nominal Value/PriceIndex)*100 • Real Wage = Nominal Wage/PriceIndex)*100
$1000 buys half a basket, so you are getting half the salary compared to Base year $1000 in real terms is equal to $500
Meaning of Real values $100,000 CPI = 100 $100,000 CPI = 200 Cost of Basket Cost of Basket = 1 = 2 Cost of Basket base Cost of Basket base Cost of Basket is the same as in base Real = (Nominal/CPI)*100 Cost of Basket is twice the cost in base The real value of $100,000 is: (100,000/100)*100 =$100,000 The real value of $100,000 is: (100,000/200)*100 =$50,000 $100,000 buy $100,000 worth of basket goods $100,000 buy $50,000worth of basket goods
The Core Consumer Price Index The CPI Measures what consumers are paying for goods and services at malls, grocery stores and other retail locations. Unlike the overall CPI, the core CPI excludesfood and energy prices, which can bounce around enough each month to distort the overall price trend picture. For the most recent core CPI data, click here.
Updating the Market Basket • CPI revisions occur approximately every 10 years. • The most important revision is the introduction of a new “market basket” • The last revision to the CPI started in 1998 and completed in 2000.
Why is the CPI important? • Government use prices to set interest rates. • Used in labor contracts. • Landlords use it to determine rents. • Judges use it to determine alimony and child support payments. • Used to adjust payments to: • Social Security recipients (50 million) • Federal and Military retirees • Food Stamps and School Lunches (25 million) • Used to adjust individual income tax brackets.
How is COLA calculated? Calculation is based on the increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) The first COLA, for June 1975 was calculated from the second quarter of 1974 to the first quarter of 1975. The 1976-83 COLAs were calculated from the first quarter of the prior year to the corresponding quarter of the current year in which the COLA became effective. After 1983, COLAs have been calculated from the third quarter of the prior year to the corresponding quarter of the current year in which the COLA became effective.
Inflation Rate for Year X (CPI Year X) - (CPI previous year) X 100 (CPI previous year)
You need 100% more money in 2009 than in 2008 to buy the same amount. twice as much Inflation: Change in CPI relative to previous period
Comparing dollar values from different years $100 in 1930 is not the same as $100 today. $100 buy more when prices are lower. What is the equivalent of $100 of 1930 in today’s prices? How much money do I need today to buy what $100 used to buy in 1930?
Moving dollar values forward in time… CPI (1930) = 16.7 CPI (2011) = 226 1930 2011 Multiply by 13.5 (226)/(16.7) =13.5 ? $1,350 $100 Prices in 2011 are 13.5 times larger than in 1930 You need to have 13.5 times as much money in 2011
Comparing dollar values across cities • $40,000 in Boston • $35,000 in Kansas City. Are these salaries comparable? How much money do I need in Kansas City to buy what $40,000 buy in Boston? CPI (Boston) =250 CPI (Kansas City) = 200 40,000 $?
Boston offer is equivalent to $32,000 CPI (Boston) =250 CPI (Kansas City) = 200 $32,000 40,000 200 / 250 = 0.8 Prices in Kansas City are 80% of prices in Boston. In Kansas, you need 80% of the money you need in Boston: 40,000*0.8= $32,000 Kansas City Offer is better To buy the same basket of goods you buy with $40,000 in Boston, in Kansas City you only need 32,000. Kansas City offer is $35,000
Or…you can compare Real Values CPI (Boston) =250 CPI (Kansas City) = 200 40,000 $35,000 (40,000/250)*100 =16,000 (35,000/200)*100 = 17,500 In real terms the KC offer is 1,500 real dollars higher
Inflation • Refers to an INCREASE in the price level from one period to the next. • Inflation can be high (20%) or low (2%) • When inflation drops from 20% to 2% prices still INCREASE, not as much as the previous time period but increase.
Deflation • Refers to a DECREASE in the price level from one period to the next. • Deflation results in a NEGATIVE number for the inflation rate: a –5%“inflation” means that prices DECREASED by 5%. • This is not only a slowing down of inflation but a DROP in prices.
Problems Measuring the Cost of Living • Substitution Bias: Because the basket is fixed, the CPI does not account for substitutions consumers do in response to higher prices.
Geometric Mean Estimator Substitution from “frozen desserts” to “cake-like desserts” Old Basket: 3 apples 4 ice cream bars • Employs a set of fixed expenditure proportions as weights. • Consumers can alter the quantities of goods and services they buy within the category, when the relative prices of those goods and services change. New Basket: 3 fruits 4 frozen desserts
Chained CPI • Utilizes expenditure data in both the current and base time periods in order to reflect the effect of any substitution that consumers may make across item categories in response to changes in relative prices. • On average, the chained CPI is less than the conventional CPI by 0.25 to 0.3 percentage points. • The Bureau of Labor Statistics has been tracking chained CPI since 2002.
2.0 MB floppy to 256 Gb flash drive Problems with CPI… • New Goods Bias: Not included in the basket. Consumers spend less to attain the same (or higher) standard of living. CPI does not reflect this change in the purchasing power of a dollar. • Unmeasured Quality change: If quality improves, the value of the dollar rises.
The GDP Deflator v.s CPI GDP Deflator CPI Reflects prices of goods purchased by consumers ONLY! Reflects prices of ALL goods and services produced purchased by Consumers, Firms, Government, Other countries.
(c) 2000,2001, 2002 Claudia Garcia - Szekely The GDP Deflator vs. CPI GDP Deflator CPI Uses a basket with same goods and same quantities Uses the Market Basket Uses a basket with different goods and different quantities Uses current production items and quantities.
Inflation Calculator This site finds the equivalencies for dollars in different years. http://data.bls.gov/cgi-bin/cpicalc.pl
Measuring Prices • The Consumer Price Index (CPI) measures inflation as experienced by consumers in their day-to-day living expenses • The Producer Price Index (PPI) measures inflation at earlier stages of the production process • The Employment Cost Index (ECI) measures inflation in labor costs • The BLS International Price Program measures price changes for imports and exports • The Gross Domestic Product Deflator (GDP Deflator) measures inflation experienced by both consumers themselves as well as governments and other institutions providing goods and services to consumers.