HS21201

ECONOMICS
TO P I C
I I T K H A R AG P U R ( S P R I N G ‘ 2 3 )
A N U B H A B PAT TA N AYA K
NOMINAL VS. REAL GDP

• US GDP was $20,500 billion in 2018, compared to $543 billion in 1960.

• Was US output really almost 38 times higher in 2018 than in 1960?
• No: Much of the increase reflected an increase in prices rather than an increase in
quantities produced.
• This leads to the distinction between nominal GDP and real GDP.
• Nominal GDP is the sum of the quantities of final goods produced times their current
price. Nominal GDP is also called GDP in ‘current’ prices.
• If Qt is total output/production and P t is current/prevailing prices at time t then:
NOMINAL VS. REAL GDP

• Nominal GDP – use ‘current’ year prices

• Real GDP – use price prevailing in a given year to compare the values
across years.
T H E I N F L AT I O N R AT E

• Inflation is a sustained rise in the general level of prices (or Price level).
• Inflation rate is the rate at which the price level increases.
• Deflation is a sustained decline in the price level.
• Two measures of the price level: GDP deflator and the Consumer Price Index (CPI)
G D P D E F L AT O R

• GDP deflator is an index number; simple relation between nominal and real GDP.

• In the base chosen

year GDP deflator value isit1.is equal to 1 in 2012—and has no economic interpretation.
arbitrarily—here
• But its rate of change, (Pt - Pt - 1)>Pt - 1 (which we shall denote by pt in the rest of the
Inflation rate:
book), has a clear economic interpretation: It gives the rate at which the general level of
prices increases over time—the rate of inflation.
One advantage to defining the price level as the GDP deflator is that it implies a sim-
ple relation between nominal GDP, real GDP, and the GDP deflator. To see this, reorganize
the previous equation to get:
$Yt = PtYt
Nominal GDP is equal to the GDP deflator times real GDP. Or, putting it in terms of rates
CONSUMER PRICE INDEX (CPI)

• Need?
• Consumers care about the average price of goods they consume (consumption).
• CPI need not be the same as GDP deflator: the set of goods produced in the economy
is not the same as the set of goods consumed.
a) Some goods are not sold to consumers but to firms (e.g., machines) or government or
foreigners
b) Some goods bought by consumers are not domestically produced but imported from abroad.
• To measure the average price of consumption or equivalently, the cost of living, CPI is
measured.
• CPI gives the cost (in rupees) of a specific list of goods and services over time.
• Which list?
CONSUMER PRICE INDEX (CPI)

• The list, which is based on a detailed study of consumer spending, attempts to represent
the consumption basket of a typical urban consumer and is updated every few years.
• E.g., Each month, Bureau of Labor Statistics (BLS) employees visit stores to find out what has
happened to the price of the goods on the list; prices are collected for 211 items in 38 cities.
These prices are then used to construct the CPI.
• CPI is an index and is 100 in the period chosen as the base period; level has no
particular significance.
• If base = 1982 then CPI in 1982 = 100;
• If in 2018, CPI = 250, then it cost 2.5 times as much in dollars to purchase the same
“Basket” of goods and services.
Figure 2-4 16.0

Inflation Rate, Using 14.0

the CPI and the GDP

Inflation Rate (percent per year)

Deflator, 1960–2018. 12.0
CPI inflation
The inflation rates, computed 10.0
using either the CPI or the
GDP deflator, are largely 8.0
similar.
6.0
Source: FRED: CPIAUCSL and
GDPDEF.
4.0

2.0 GDP deflator inflation

0.0

22.0
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
WHY DO ECONOMISTS CARE ABOUT
I N F L AT I O N ?
• Inflation is not bad per se.
• Then why worry?
• During periods of inflation, not all prices and income rise proportionately.
Consequently, inflation affects income distribution. E.g., retired employees receive
payments that don’t keep up with the price level. So they lose (relative to other earning
groups) when inflation is high. (Not the case in US).
• Other distortions:
• Variation in relative prices means more uncertainty. Thus, firms making investment
decisions about the future is difficult. Taxes interact with inflation. If tax brackets are
not adjusted for inflation, when people move into higher and higher tax brackets as
their nominal income increases, even if their real income remains the same.
D E F L AT I O N

• If inflation is so bad, does this imply that deflation (negative inflation) is good?
• No
• High deflation (a large negative rate of inflation) would create many of the same
problems as high inflation, from distortions to increased uncertainty.
• low rate of deflation limits the ability of monetary policy to affect (increase) output.

• So what is the “best” rate of inflation?

• Most macro- economists believe that the best rate of inflation is low and stable,
somewhere between 1% and 4%.