Macroeconomics Study Guides

Principles of Macroeconomics Lecture Notes

PART II: Inflation

Real versus Nominal variables

Using current market values allows summing different types of goods and services, but how to compare variables over time?

Production today

20 computers

20 bicycles

Production tomorrow

20 computers

20 bicycles

If prices of computers and bicycles double between today and tomorrow, the current market value of GDP (i.e., nominal GDP) also doubles. However, the amount of physical production remains unchanged.
What's wrong? Nominal GDP today is expressed in terms of dollars of today and nominal GDP tomorrow is expressed in terms of dollars of tomorrow. If there is inflation, the purchasing power of the dollar has changed over time.
By looking at the current market value of goods changes over time, you can't tell whether this change reflects changes in the goods produced or in their prices. That is why we need to look at the "real" GDP or at constant prices.

Prices and Inflation

To compare the market value of output over time, we need to know how does the purchasing power of 1$ change over time. For that we need a price index.
How Are Prices Measured?
Price Indexes measure the cost of a fixed 'basket' of goods over time

$P(t) \approx \sum_{g} w_{g} p_{g}(t)$

(weights are usually fixed or slowly moving)

Inflation rate = % change in P, where P is the general price level

$\text{– Inflation = [P(t+1) - P(t)] / P(t)}$

Prices and Inflation

GDP Deflator (one prominent price index):

$\text{Value of Current Output at Current Prices /}$

$\text{Value of Current Output at Base Year Prices}$

Another prominent price index is the CPI (consumer price index) – measures price changes of consumer goods. BLS surveys over 80,000 goods per month in different locations around the country.
I will often use the CPI as our measure of a price index in this class.

Using Prices to distinguish between Nominal and Real Variables

Nominal GDP is output valued at Current Prices
Comparing Nominal GDPs over time can become problematic

Confuses changes in Output (production) with changes in prices

Real GDP is output valued at some Constant Level of Prices (prices in a base year).

$\text{Real GDP(t) = Nominal GDP(t) / Price Index (t)}$

Growth in Real GDP:

$\text{% Δ in Real GDP = [Real GDP (t+1) - Real GDP (t)] / Real GDP (t)}$

or (approximately)

$\text{% Δ in Real GDP = % Δ in Nominal GDP - % Δ in P}$

Example of Price Index Calculations

Veronica's Basket of Goods (goods I produce in my world)

	2000			2008
	Q	P	Y	Q	P	Y
Books	10	1.00	10.00	20	2.00	40.00
Wine	15	3.00	45.00	20	4.00	80.00
Clothes	50	0.50	25.00	40	1.00	40.00

Y(2000) = 80.00 (10 + 45 + 25)

Y(2008) = 160.00 (40 + 80 + 40)

Nominal GDP went up by 100%!

Compute GDP Deflator for Veronica's World (with 2000 as Base Year)

	2000			2008
	Q	P	Y	Q	P	Y
Books	10	1.00	10.00	20	2.00	40.00
Wine	15	3.00	45.00	20	4.00	80.00
Clothes	50	0.50	25.00	40	1.00	40.00

Current Output at Current Prices: 160.00

Current Output at Base Year Prices: 100.00 (1*20 + 3*20 +0.50*40)

GDP Deflator for 2000 = 1.00 (Price Index in the Base Year ALWAYS = 1)

GDP Deflator for 2008 = 1.60

Inflation Rate Between 2000 and 2008 = 60%

What is real GDP growth between 2000 and 2008 in Veronica's World? 40% (approx).

What is real GDP growth between 2000 and 2008 in Veronica's World? 25% (actual)

Notes on Price Indexes

Need to Pick a Basket of Goods (cannot measure all prices)
'Ideal/Representative' Basket of Goods Change Over Time

Invention (Computers, Cell Phones, VCRs, DVDs).
Quality Improvements (Anti-Lock Brakes)

Criticisms of Price Indices:

Part of the Change in Prices Represents a Change in Quality - Actually, not measuring the same goods in your basket over time.
Technology advances drive down the price of 'same' goods over time
Substitution of goods in reaction to prices changes
Arbitrary choice of the goods (Housing included in US CPI not in EU CPI)
How do we account for "sales"?

Boskin Report Concludes that CPI Overstates Inflation by 1.1% per year (quality adjustment/substitution bias)
Overstating Inflation means understated Real GDP increases - makes it appear that the U.S. Economy has Grown Slower Over Time. (Same for Stock Market, Housing Prices, Wages - any Nominal Measure)
Measures to Get Around Problems with CPI - Chain Weighting

Read Box 2.2 in the Text to get a sense of chain weighting

Focus on Real Variables

Which is better: Real or Nominal?

In this class, we will focus on the 'Real'! We are trying to measure changes in production, expenditures, income, standard of livings, etc. We will separately focus on the changes in prices.
From now on, both in the analytical portions and the data portions of the course, we will assume everything is real unless otherwise told.

ie, $\text{Y = Real GDP, C = Real Consumption, G = Real Government Purchases, etc...}$