measuring a nation’s income · measuring a nation’s income and the cost of living henan...

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Lesson 7

Measuring a Nation’s Income

and the Cost of Living

Henan University of Technology

Sino-British College

Transfer Abroad Undergraduate Programme

1

In this lesson, look for the answers to these

questions:

What is Gross Domestic Product (GDP)?

How is GDP related to a nation’s total income

and spending?

What are the components of GDP?

How is GDP corrected for inflation?

Does GDP measure society’s well-being?

2

In this lesson, look for the answers to these

questions:

What is the Consumer Price Index (CPI)?

How is it calculated? What’s it used for?

What are the problems with the CPI?

How does the CPI differ from the GDP deflator?

How can we use the CPI to compare dollar

amounts from different years?

How can we correct interest rates for inflation?

3

Micro vs. Macro

Microeconomics:

The study of how individual households and

firms make decisions, interact with one another

in markets.

Macroeconomics:

The study of the economy as a whole.

We begin our study of macroeconomics with the

country’s total income and expenditure.

4

Income and Expenditure

Gross Domestic Product (GDP) measures

total income of everyone in the economy.

GDP also measures total expenditure on the

economy’s output of g&s.

For the economy as a whole,

income equals expenditure, because

every dollar a buyer spends

is a dollar of income for the seller.

5

…the market value of all final goods &

services produced within a country

in a given period of time.

Gross Domestic Product (GDP) Is…

Goods are valued at their market prices, so:

• all goods measured in the same units

(e.g., dollars in the U.S.)

• Things that don’t have a market value are

excluded, e.g., housework you do for yourself.

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Final goods: intended for the end user

Intermediate goods: used as components

or ingredients in the production of other goods

GDP only includes final goods – they already

embody the value of the intermediate goods

used in their production.

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GDP includes tangible goods

(like DVDs, mountain bikes, beer)

and intangible services

(dry cleaning, concerts, cell phone service).

8





GDP includes currently produced goods,

not goods produced in the past.

9





GDP measures the value of production that occurs

within a country’s borders, whether done by its own

citizens or by foreigners located there.

10





usually a year or a quarter (3 months)

11

The Components of GDP

Recall: GDP is total spending.

Four components:

• Consumption (C)

• Investment (I)

• Government Purchases (G)

• Net Exports (NX)

These components add up to GDP (denoted Y):

Y = C + I + G + NX

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Consumption (C)

is total spending by households on g&s.

Note on housing costs:

• For renters, consumption includes rent

payments.

• For homeowners, consumption includes

the imputed rental value of the house,

but not the purchase price or mortgage

payments.

13

Investment (I)

is total spending on goods that will be used in

the future to produce more goods.

includes spending on

• capital equipment (e.g., machines, tools)

• structures (factories, office buildings, houses)

• inventories (goods produced but not yet sold)

Note: “Investment” does not

mean the purchase of financial

assets like stocks and bonds.

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Government Purchases (G)

is all spending on the g&s purchased by govt

at the federal, state, and local levels.

G excludes transfer payments, such as

Social Security or unemployment insurance

benefits.

They are not purchases of g&s.

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Net Exports (NX)

NX = exports – imports

Exports represent foreign spending on the

economy’s g&s.

Imports are the portions of C, I, and G

that are spent on g&s produced abroad.

Adding up all the components of GDP gives:

Y = C + I + G + NX

16

U.S. GDP and Its Components, 2007

–2,344

8,905

7,037

32,228

$45,825

per capita

–5.1

19.4

15.4

70.3

100.0

% of GDP

–708

2,690

2,125

9,734

$13,841

billions

NX

G

I

C

Y

17

GDP components: US vs. China

A C T I V E L E A R N I N G 1:

GDP and its components

18

In each of the following cases, determine how much

GDP and each of its components is affected (if at all).

A. Debbie spends $200 to buy her husband dinner

at the finest restaurant in Boston.

B. Sarah spends $1800 on a new laptop to use in her

publishing business. The laptop was built in China.

C. Jane spends $1200 on a computer to use in her

editing business. She got last year’s model on sale

for a great price from a local manufacturer.

D. General Motors builds $500 million worth of cars,

but consumers only buy $470 million worth of them.


Answers

19

A. Debbie spends $200 to buy her husband dinner

at the finest restaurant in Boston.

Consumption and GDP rise by $200.

B. Sarah spends $1800 on a new laptop to use in

her publishing business. The laptop was built in

China.

Investment rises by $1800, net exports fall

by $1800, GDP is unchanged.


Answers

20

C. Jane spends $1200 on a computer to use in her

editing business. She got last year’s model on

sale for a great price from a local manufacturer.

Current GDP and investment do not change,

because the computer was built last year.

D. General Motors builds $500 million worth of cars,

but consumers only buy $470 million of them.

Consumption rises by $470 million,

inventory investment rises by $30 million,

and GDP rises by $500 million.

21

Real versus Nominal GDP

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.

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EXAMPLE:

Compute nominal GDP in each year:

2002: $10 x 400 + $2 x 1000 = $6,000

2003: $11 x 500 + $2.50 x 1100 = $8,250

2004: $12 x 600 + $3 x 1200 = $10,800

Pizza Latte

year P Q P Q

2002 $10 400 $2.00 1000

2003 $11 500 $2.50 1100

2004 $12 600 $3.00 1200

37.5%

Increase:

30.9%

23

EXAMPLE:

Compute real GDP in each year,

using 2002 as the base year:

Pizza Latte

year P Q P Q

2002 $10 400 $2.00 1000

2003 $11 500 $2.50 1100

2004 $12 600 $3.00 1200

20.0%

Increase:

16.7%

$10 $2.00

2002: $10 x 400 + $2 x 1000 = $6,000

2003: $10 x 500 + $2 x 1100 = $7,200

2004: $10 x 600 + $2 x 1200 = $8,400

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EXAMPLE:

In each year,

nominal GDP is measured using the (then)

current prices.

real GDP is measured using constant prices from

the base year (2002 in this example).

year

Nominal

GDP

Real

GDP

2002 $6000 $6000

2003 $8250 $7200

2004 $10,800 $8400

25

EXAMPLE:

The change in nominal GDP reflects both prices

and quantities.

year

Nominal

GDP

Real

GDP

2002 $6000 $6000

2003 $8250 $7200

2004 $10,800 $8400

20.0%

16.7%

37.5%

30.9%

The change in real GDP is the amount that

GDP would change if prices were constant

(i.e., if zero inflation).

Hence, real GDP is corrected for inflation.

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The GDP Deflator

The GDP deflator is a measure of the overall

level of prices.

Definition:

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.

GDP deflator = 100 xnominal GDP

real GDP

27

EXAMPLE:

Compute the GDP deflator in each year:

year

Nominal

GDP

Real

GDP

GDP

Deflator

2002 $6000 $6000

2003 $8250 $7200

2004 $10,800 $8400

2002: 100 x (6000/6000) = 100.0

100.0

2003: 100 x (8250/7200) = 114.6

114.6

2004: 100 x (10,800/8400) = 128.6

128.6

14.6%

12.2%


Computing GDP

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Use the above data to solve these problems:

A. Compute nominal GDP in 2004.

B. Compute real GDP in 2005.

C. Compute the GDP deflator in 2006.

2004 (base yr) 2005 2006

P Q P Q P Q

good A $30 900 $31 1,000 $36 1050

good B $100 192 $102 200 $100 205


Answers

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A. Compute nominal GDP in 2004.

$30 x 900 + $100 x 192 = $46,200

B. Compute real GDP in 2005.

$30 x 1000 + $100 x 200 = $50,000

2004 (base yr) 2005 2006

P Q P Q P Q

good A $30 900 $31 1,000 $36 1050

good B $100 192 $102 200 $100 205


Answers

30

C. Compute the GDP deflator in 2006.

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

2004 (base yr) 2005 2006

P Q P Q P Q

good A $30 900 $31 1,000 $36 1050

good B $100 192 $102 200 $100 205

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GDP and Economic Well-Being

Real GDP per capita is the main indicator of

the average person’s standard of living.

But GDP is not a perfect measure of

well-being.

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GDP Does Not Value:

the quality of the environment

leisure time

non-market activity, such as the child care

a parent provides his or her child at home

an equitable distribution of income

33

Then Why Do We Care About GDP?

Having a large GDP enables a country to afford

better schools, a cleaner environment,

health care, etc.

Many indicators of the quality of life are

positively correlated with GDP.

34

China, growth rate of real GDP

35

GDP China, USA, India

36

The Consumer Price Index (CPI)

Measures the typical consumer’s cost of living.

The basis of cost of living adjustments (COLAs)

in many contracts

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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.

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How the CPI Is Calculated

4. Choose a base year and compute the index.

The CPI in any year equals

5. Compute the inflation rate.

The percentage change in the CPI from the

preceding period.

100 xcost of basket in current year

cost of basket in base year

CPI this year – CPI last year

CPI last year

inflation

ratex 100%=

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EXAMPLE basket: {4 pizzas, 10 lattes}

$12 x 4 + $3 x 10 = $78

$11 x 4 + $2.5 x 10 = $69

$10 x 4 + $2 x 10 = $60

cost of basket

$3.00

$2.50

$2.00

price of

latte

$122005

$112004

$102003

price of

pizzayear

Compute CPI in each year

2003: 100 x ($60/$60) = 100

2004: 100 x ($69/$60) = 115

2005: 100 x ($78/$60) = 130

Inflation rate:

15%115 – 100

100x 100%=

13%130 – 115

115x 100%=

using 2003 base year:


Calculate the CPI

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CPI basket:

{10 lbs beef,

20 lbs chicken}

The CPI basket cost $120

in 2004, the base year.

A. Compute the CPI in 2005.

B. What was the CPI inflation rate from 2005-2006?

price

of beef

price of

chicken

2004 $4 $4

2005 $5 $5

2006 $9 $6


Answers

41

beef chicken

2004 $4 $4

2005 $5 $5

2006 $9 $6

A. Compute the CPI in 2005:

Cost of CPI basket in 2005

= ($5 x 10) + ($5 x 20) = $150

CPI in 2005 = 100 x ($150/$120) = 125

CPI basket:

{10 lbs beef,

20 lbs chicken}




Answers

42

beef chicken

2004 $4 $4

2005 $5 $5

2006 $9 $6

CPI basket:

{10 lbs beef,

20 lbs chicken}



B. What was the inflation rate from 2005-2006?

Cost of CPI basket in 2006

= ($9 x 10) + ($6 x 20) = $210

CPI in 2006 = 100 x ($210/$120) = 175

CPI inflation rate = (175 – 125)/125 = 40%

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What’s in the CPI’s Basket?

42%

17%

15%

6%

6%

6%

4%4% Housing

Transportation

Food & Beverages

Medical care

Recreation

Education andcommunication

Apparel

Other


Substitution bias

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CPI basket:

{10 lbs beef,

20 lbs chik}

2004-5:

Households

bought CPI basket.

2006: Households bought {5 lbs beef, 25 lbs chik}.

A. Compute cost of the 2006 household basket.

B. Compute % increase in cost of household basket

over 2005-6, compare to CPI inflation rate.

beef chickencost of CPI

basket

2004 $4 $4 $120

2005 $5 $5 $150

2006 $9 $6 $210


Answers

45

CPI basket:

{10 lbs beef,

20 lbs chik}

Household

basket in 2006:

{5 lbs beef, 25 lbs chik}


basket

2004 $4 $4 $120

2005 $5 $5 $150

2006 $9 $6 $210

A. Compute cost of the 2006 household basket.

($9 x 5) + ($6 x 25) = $195


Answers

46

CPI basket:

{10 lbs beef,

20 lbs chik}

Household

basket in 2006:

{5 lbs beef, 25 lbs chik}

B. Compute % increase in cost of household basket

over 2005-6, compare to CPI inflation rate.

Rate of increase: ($195 – $150)/$150 = 30%

CPI inflation rate from previous problem = 40%


basket

2004 $4 $4 $120

2005 $5 $5 $150

2006 $9 $6 $210

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Problems With the CPI: Substitution Bias

Over time, some prices rise faster than others.

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.

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Problems With the CPI: Introduction of New Goods

When new goods become available,

variety increases, allowing consumers to find

products that more closely meet their needs.

This has the effect of making each dollar 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.

49

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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Imported consumer goods:

included in CPI

excluded from GDP deflator

The basket:

CPI uses fixed basket

GDP deflator uses basket of

currently produced goods & services

This matters if different prices are

changing by different amounts.

Capital goods:

excluded from CPI

included in GDP deflator

(if produced domestically)

Contrasting the CPI and GDP Deflator


CPI vs. GDP deflator

51

In each scenario, determine the effects on the

CPI and the GDP deflator.

A. Starbucks raises the price of Frappuccinos.

B. Caterpillar raises the price of the industrial

tractors it manufactures at its Illinois factory.

C. Armani raises the price of the Italian jeans it

sells in the U.S.


Answers

52

A. Starbucks raises the price of Frappuccinos.

The CPI and GDP deflator both rise.

B. Caterpillar raises the price of the industrial

tractors it manufactures at its Illinois factory.

The GDP deflator rises, the CPI does not.

C. Armani raises the price of the Italian jeans it

sells in the U.S.

The CPI rises, the GDP deflator does not.

53

Correcting Variables for Inflation:

Comparing Dollar Figures from Different Times

Inflation makes it harder to compare dollar

amounts from different times.

We can use the CPI to adjust figures so that

they can be compared.

54

EXAMPLE: The High Price of Gasoline

Price of a gallon of regular unleaded gas:

$1.42 in March 1981

$3.03 in February 2008

To compare these figures, we will use the CPI to

express the 1981 gas price in “2008 dollars,”

what gas in 1981 would have cost if the

cost of living were the same then as in 2008.

Multiply the 1981 gas price by

the ratio of the CPI in 2008 to the CPI in 1981.

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211.7$3.03/gallon2/2008

88.5$1.42/gallon3/1981

CPIPrice of gasdate

EXAMPLE: The High Price of Gasoline

1981 gas price in 2008 dollars

= $1.42 x 211.7/88.5

= $3.40

After correcting for inflation, gas was more

expensive in 1981.

$3.03/gallon

$3.40/gallon

Gas price in

2005 dollars


Exercise

1980: CPI = 90,

avg starting salary for econ majors = $24,000

Today: CPI = 180,


Are econ majors better off today or in 1980?

56


Answers

57

Solution

Convert 1980 salary into “today’s dollars”

$24,000 x (180/90) = $48,000.

After adjusting for inflation, salary is higher today

than in 1980.

1980: CPI = 90,


Today: CPI = 180,


58


Indexation

For example, the increase in the CPI automatically

determines

• the COLA in many multi-year labor contracts

• the adjustments in Social Security payments

and federal income tax brackets

A dollar amount is indexed for inflation

if it is automatically corrected for inflation

by law or in a contract.

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Real vs. Nominal Interest Rates

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)

60

Real and Nominal Interest Rates: 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%.

61

LESSON SUMMARY

Gross Domestic Product (GDP) measures a

country’s total income and expenditure.

The four spending components of GDP include:

Consumption, Investment, Government

Purchases, and Net Exports.

Nominal GDP is measured using current prices.

Real GDP is measured using the prices of a

constant base year, and is corrected for inflation.

GDP is the main indicator of a country’s economic

well-being, even though it is not perfect.

62

LESSON SUMMARY

The Consumer Price Index is a measure of the

cost of living. The CPI tracks the cost of the

typical consumer’s “basket” of goods & services.

The CPI is used to make Cost of Living

Adjustments, and to correct economic variables for

the effects of inflation.

The real interest rate is corrected for inflation,

and is computed by subtracting the inflation rate

from the nominal interest rate.

measuring a nation’s income · measuring a nation’s income and the cost of living henan...

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