TODAYTODAY

Simple problems illustrating the Simple problems illustrating the computation of GDP and real GDPcomputation of GDP and real GDP

Define price indexesDefine price indexes

InflationInflation

Use price index to compute real Use price index to compute real quantities (out of nominal data)quantities (out of nominal data)

Some simple review problems (1)Some simple review problems (1)

If a pizza maker pays $1 for tomatoes, $1 If a pizza maker pays $1 for tomatoes, $1 for cheese, $2 for sausage, and sells the for cheese, $2 for sausage, and sells the pizza made with these ingredients for $7, pizza made with these ingredients for $7, then each pizza sold contributes how then each pizza sold contributes how much to GDP?much to GDP?

– $3$3– $4$4– $7$7– $9$9

Simple review problems (2)Simple review problems (2)

In the above table, which of the following is true In the above table, which of the following is true concerning changes between 1992 and 2002?concerning changes between 1992 and 2002?– A) Nominal and real GDP both increased.A) Nominal and real GDP both increased.– B) Nominal GDP increased, but real GDP was B) Nominal GDP increased, but real GDP was

unchanged. unchanged.– C) Nominal GDP increased, but real GDP C) Nominal GDP increased, but real GDP decreased.decreased.– D) None of the above statements are trueD) None of the above statements are true

Year Prices Nominal GDP 1982 100 $1,600 1992 150 $3,000 2002 300 $6,000

Simple review problems (3)Simple review problems (3)

The above table reports data for The above table reports data for book-and-pen-country during 2004 book-and-pen-country during 2004 and 2005and 2005

What was the real GDP of book-and-What was the real GDP of book-and-pen country during 2004 (if the base pen country during 2004 (if the base year is 2005)?year is 2005)?

Measuring the price level Measuring the price level and inflationand inflation

Price indexesPrice indexes

• It is useful to have a single number that summarizes the overall price level of the economy

• Price indexes help us obtaining real quantities out of nominal ones

• For any period, a price index measures the cost of a basket of goods relative to the cost of the same basket in a fixed year (called base year)

How to compute a price indexHow to compute a price index

• Determine the base year

• Determine the “representative basket” (consumption goods, production goods, all goods in GDP, etc)

• To construct the price index in year t, multiply prices of period t by the quantities in the representative basket. Finally, divide by the cost of the rep. basket during the base year

Price index, Example 1Price index, Example 1

Basket is:Rent, pizza rustica,

entertainment

Base year 2003Rent (1): $2000Pizza (10): $ 100Entert. (5):$ 900Cost = $ 3000

Year 2004Rent (1): $2,200Pizza (10): $ 110Entert. (5): $ 990Cost = $3,300

Price index2004(2003=1)= $3,300/$3,000 =1.1

Price index, Example 2Price index, Example 2

Compute price index for 2005 (base 2004).

What is inflation? how do we What is inflation? how do we measure it?measure it?

• Inflation is the sustained increase in the overall price level of the economy (if the price level goes down, then we say there is deflation)

• We measure inflation (deflation) by the percentage increase (decrease) in the corresponding price index

• The standard price index used to compute inflation is the CPI (consumer’s price index)

Measuring inflation, Ex. 1Measuring inflation, Ex. 1

• According to the BEA, the CPI during 2006 (Q2) = 1.1459. The CPI during 2006 (Q1) = 1.1344.

• What was the inflation rate from the first to the second quarter of 2006?

Computing real quantities Computing real quantities out of nominal quantitiesout of nominal quantities

• An important use of price indexes is to adjust nominal quantities for the effects of inflation

• Using price indexes we can deflate a nominal quantity and transform it into a real quantity, which is measured in physical terms (goods and services) – real quantities are what economists care about

Computing real quantities Computing real quantities (contd)(contd)

• How?

Dividing a nominal quantity by an appropriate price index obtains a real quantity (with base equal to that of the price index)

Using a price index (Example Using a price index (Example 1)1)

• Suppose you invested $100 in the stock market on 1986

• Stock market index has increased by a factor of 6

• Does this mean I can buy 6 times more goods and services than what I sacrificed in 1986?

Example 1: contdExample 1: contd

Example 1 (contd)Example 1 (contd)

• From Yahoo, the S&P 500– Index (1986) = 200– Index (2004) = 1163

• The BLS reports the consumer price index– CPI (1986) = 109.6– CPI (2004) = 188.9

Real stock mkt 1986 =1.8248Real stock mkt 2004 =6.1566Real return is roughly 3-fold (6.15/1.82)(as opposed to 6-fold in nominal terms)