Spring, 2017

Price level and InflationNominal v.s Real GDP

Instructor: Xi Wang

GDP Review

• Review of GDP; Key: Market Value, Final goods.

GDP Review

• A decomposition of value of Final Goods:• To make coffee, say you need Coffee beans, Cups, Milk, coffee machines.• Say for per cup of coffee, Starbucks spend $0.5 to purchase coffee beans,

$0.2 for cups, $0.3 for milk. We spend $1.5 to purchase this cup of coffee.(Final value)

• The value added for starbucks is $0.5. Why starbucks provide labor and machine to make this cup of coffee. So they contribute $0.5 to this cup of coffee.

• Any other contributions? Coffee bean provider $0.5, Cup provider $0.2, milk $0.3.

Does GDP overestimate our living standard?

Does GDP overestimate our living standard?

Living standard: I

• Say I have a bagel, an apple, a cup of milk as breakfast

• And I have a piece of steak (0.6 pound) as lunch

• Furthermore, I have a bowel of white rice, 1 mango, 0.5 pound of lamb as dinner

• Then my daily consumption basket would be

• 1 bagel + a cup of milk + 0.6 pound steak + 1 bowel of rice + 1 mango +0.5 pound of lamb

• Then my weekly consumption basket would be 7 times this daily basket

Living standard: II

• If My daily consumption basket worth $ 3 in 1929

• My weekly consumption basket then worth $3X7= $21

• Yes? Ok, what if I have weekly wage $21?

• I can consume one consumption basket, right?

• Then, what if I have weekly wage $25?

• Will I have a better living standard?

• Yes, People will state that you could consume more now! From Econ 101, more is better(25/21>1)

Living standard: III

Does this Logic make sense? If not, is the meansure still right?

• Consume more is not always true. Will you consume two iphone if you are rich?

• In some circumstance, consuming more is not an option.

• Example: Yes I only need to consume one daily consumption basket. NO More

• But upgrading your consumption can be always a candidate.

• But I can choose to purchase lamb from Wholfood or Walmart.

Living standard: IV

Living standard: V

Summary I

Summary II

Price of Consumption Bundle: CPI

1980in Basket of Value1929in Basket of Value

CPI : An Example, Base year: 1980Year Price of

ApplePrice of Banana

Price of Avacado

Price of Pineapple

Value of Basket

CPI(Base year: 1980)

1960 1 0.6 1 0.7 5.9 5.9/13.95

1970 2 0.8 2 0.9 10.5 10.5/13.95

1975 2.3 0.9 2.6 1.1

1979 2.5 1 2.7 1.3

1980 2.5 1.1 2.75 1.5 13.95 1

1990 3 1.5 3 2

2000 3.7 2 3.5 2.5

Basket 3 2 1 1

CPI : An Example, Base year: 1960Year Price of

ApplePrice of Banana

Price of Avacado

Price of Pineapple

Value of Basket

CPI(Base year: 1960)

1960 1 0.6 1 0.7 5.9 5.9/5.9

1970 2 0.8 2 0.9 10.5 10.5/5.9

1975 2.3 0.9 2.6 1.1

1979 2.5 1 2.7 1.3

1980 2.5 1.1 2.75 1.5 13.95 13.95/5.9

1990 3 1.5 3 2

2000 3.7 2 3.5 2.5

Basket 3 2 1 1

CPI

GDP adjustment by CPI

• Given a basket of consumption

• How many consumption bundles does our current GDP worth?

• Pepole are lazy so they use:

t

t

basket of ValueGDP

GDP Realbasket of Value ofIndex

GDP

t

t

GDP adjustment by CPI: Example

• CPI 1980, 1990 = 1, 1.5

• GDP of 1980, 1990 is 2.8, 5.9 trillion U.S. dollars

• Then GDP (adjusted by CPI) 1980 = 2.8/1=2.8 Tri l l ion u.s dollars(1980 dollar)

• Then GDP (adjusted by CPI) 1990 = 5.9/1.5=3.93 Trillion u.s dollars(1980 dollar)

Price Level and Real GDP

Then we are using 2009 price!!

Real GDP, another way to adjust price

• What we want is to measure how much we can consume.

• Real GDP is the “GDP” excluding price effect!

• Nominal GDP is the total market value of production, using current prices to

determine value per unit produced.

• Real GDP( xxxx dollars), is the total market value of production, using base year prices to determine value per unit produced.

Price Level and Real GDP, Example

• 2012 Nominal GDP=(10 Fords) × ($30,000/Ford) + (5 Chevrolets) × ($20,000/Chevrolet) = $400,000

• 2013 Nominal GDP= (10 Fords) × ($40,000/Ford) + (20 Chevrolets) × ($25,000/Chevrolet) = $900,000

Price Level and Real GDP, Example

• 2012 real GDP (2012 dollars)=(10 Fords) × ($30,000/Ford) + (5 Chevrolets) × ($20,000/Chevrolet) = $400,000

• 2013 real GDP (2012 dollars)= (10 Fords) × ($30,000/Ford) + (20 Chevrolets) × ($20,000/Chevrolet) = $700,000.

Real GDP: An Example, base year : 1960Year Price of

ApplePrice of Banana

Price of Avacado

Price of Pineapple GDP Real GDP

1960 1 0.6 1 0.7 you can calculate CPI

here1970 2 0.8 2 0.9

1975 2.3 0.9 2.6 1.1

Production quantities --------------- ----------------- ------------ ------------------ ------------------ -----------------

1960 1 2 3 4 1x1+2x0.6+3x1+4x0.7

1x1+2x0.6+3x1+4x0.7

1970 2 3 4 5 2x2+3x0.8+4x2+5x0.9

2x1+3x0.6+4x1+5x0.7

1975 3 4 5 63x2.3+4x0.9+5x2.6+6x0.

1.1

3x1+4x0.6+5x1+6x0.7

Another Price Index, GDP deflator

• GDP deflator(2013) =

• GDP deflator(1995)=

1002013in GDP (Real)

2013in GDP Nominal

1001995in GDP (Real)

1995in GDP Nominal

Another level, GDP deflator, example

• GDP deflator(2013) =• =90000/70000*100• =128.6

• How about GDP deflator(2012) if base year is 2012?

1002013in GDP (Real)

2013in GDP Nominal

Real GDP: An Example, base year : 1960Year Price of

ApplePrice of Banana

Price of Avacado

Price of Pineapple GDP Real GDP GDP

deflator?

1960 1 0.6 1 0.7 you can calculate CPI

here1970 2 0.8 2 0.9

1975 2.3 0.9 2.6 1.1

Production quantities --------------- ---------------

-- ------------ ------------------

------------------

-----------------

1960 1 2 3 4 1x1+2x0.6+3x1+4x0.7

1x1+2x0.6+3x1+4x0.7 1

1970 2 3 4 5 2x2+3x0.8+4x2+5x0.9

2x1+3x0.6+4x1+5x0.7

18.9/11.3=0.1.67

1975 3 4 5 63x2.3+4x0.9+5x2.6+6x

1.1

3x1+4x0.6+5x1+6x0.7

30.1/14.6=2033

Price Index, Consumer Price Index, CPI

100(2013) GDP Real

(2013) GDP Nominal (2013)deflator GDP

100pricesyear base using 2013in ly domestical produced everything buying ofCost

prices 2013 using 2013in ly domestical produced everything buying ofCost

pricesyear base using goodsconsumer ofbasket particular a buying ofCost prices 2013 using goodsconsumer ofbasket particular a buying ofCost

CPI, GDP deflator are two Price Index

• 1. Both formulas use 2013 prices in the numerator and base-year prices in the denominator.

• 2. Both formulas contain a ratio that compares what it would cost to buy “stuff” in 2013 (in the numerator) to what it would have cost to buy “the same stuff” using base-year prices (in the denominator).

• 3. Both formulas also have the same interpretation: a higher ratio implies a greater price increase from the base year to 2013.

Inflation and adjusting Nominal variables

• Inflation rate 2012in Index Price

2012)in Index (Price - 2013)in Index (Price

Growth

2012in GDP (Real)2012)in GDP ((Real) - 2013)in GDP ((Real)

1990in GDP (Real)1990)in GDP ((Real) - 2010)in GDP ((Real)

Inflation and adjusting Nominal variables

• If I give you a inflation rate from base year to now

• And Nominal GDP

• You should be able to recover Real GDP or GDP adjusted by CPI

Inflation and adjusting Nominal variables: Example

• If inflation rate is 2% from 1980 to 1981 (base year is 1980)

• And Nominal gdp of 1981 is $3.2 Trillion

• Price index is 1 in the base year

• After growing by 2%, it becomes 1.02

• GDP adjusted by price = GDP/Price index= 3.2/1.02= 3.14