Chapter 2

Measuring macroeconomic variables

Hồ Thị Hoài Thương

Email: thuonght@ftu.edu.vn
 Chapter objectives

1. Gross Domestic Product

2. Consumer Price Index

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1. Gross Domestic Product (GDP)
1.1 Definition
– Market value of all final goods and services
– Produced within a country
– In a given period of time
• “GDP is the market value…”
– Market prices - reflect the value of goods and
services

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1. Gross Domestic Product
• “… of all…”
– All items produced in the economy
• And sold legally in markets
– Excludes most items
• Produced and sold illicitly
• Produced and consumed at home
• “… final…”
– Value of intermediate goods is already
included in the prices of the final goods

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1. Gross Domestic Product
• “… goods and services…”
– Tangible goods & intangible services
• “… produced…”
– Goods and services currently produced
• “… within a country…”
– Goods and services produced domestically,
regardless of the nationality of the producer
• “… in a given period of time”
– A year or a quarter
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1. Gross Domestic Product
1.2 Measurement of GDP
• Circular-flow diagram – assumptions:
• All goods and services – bought by households
• Households - spend all of their income

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Figure 1: Circular-flow diagram

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1. Gross Domestic Product
1.2 Measurement of GDP
• GDP can measure 2 things at once
– The total expenditure on newly produced goods
and services
– The total income earned from the production of
these goods and services
For an economy as a whole
– Income must equal expenditure

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1. Gross Domestic Product
1.3 Components of GDP
• Y = C + I + G + NX
– Y = GDP
– C = consumption
– I = investment
– G = government purchases
– NX = net exports

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1. Gross Domestic Product
• Consumption
– Spending by households
– On goods and services
– Exception: purchases of new housing
• Investment
– Spending on capital equipment, inventories, and
structures
– household purchases of new housing
– Inventory accumulation

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1. Gross Domestic Product
• Government purchases
– Spending on goods and services
– By local, state, and federal governments
– Does not include transfer payments

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1. Gross Domestic Product
• Net exports = Exports - Imports
– Exports
• Spending on domestically produced goods by
foreigners
– Imports
• Spending on foreign goods by domestic residents

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Table 1
GDP and its components
Total Percent
(in billions of dollars) of total
Gross domestic product, Y 100%
Consumption, C 9,732 70
Investment, I 2,132 15
Government purchases, G 2,691 19
Net exports, NX –712 -5

This table shows total GDP for the U.S. economy in 2007 and the breakdown of GDP
among its four components.
When reading this table, recall Y = C + I + G + NX.

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 Questions
What components of GDP (if any) would each
of the following transactions affect:
a. Uncle Mike buys a new house.
b. The federal government sends your
grandmother a Social Security check.
c. A family buys a new washing machine.
d. Ford sells a car from its inventory to the
Brown family.

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1. Gross Domestic Product
1.4 Real Versus Nominal GDP
• GDP rises from one year to the next
– Economy - producing a larger amount of goods
and services
– And/or goods and services are being sold at
higher prices

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1. Gross Domestic Product
• Real GDP
– Production of goods and services
– Valued at constant prices
– Designate one year as base year
– Not affected by changes in prices
• Nominal GDP
– Production of goods and services
– Valued at current prices
• For the base year
– Nominal GDP = Real GDP
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Table 2
Real and Nominal GDP
Prices and Quantities
Price of Quantity of Price of Quantity of
Year hot dogs hot dogs hamburgers hamburgers
2008 $1 100 $2 50
2009 $2 150 $3 100
2010 $3 200 $4 150
Calculating Nominal GDP
2008
2009
2010
Calculating Real GDP (base year 2008)
2008
2009
2010
Calculating the GDP Deflator
2008
2009
2010
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1. Gross Domestic Product
• The GDP deflator
– Measure of the price level
– Ratio of nominal GDP to real GDP times 100
– =100 for the base year
• Inflation
– Economy’s overall price level is rising

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1. Gross Domestic Product
• Inflation rate
– Percentage change in some measure of the
price level from one period to the next
GDP deflator in year 2 - GDP deflator in year 1
Inflationin year 2 =  100
GDP deflator in year 1

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1.4 GDP - Good Measure of Economic Well-being?

• GDP – a good measure of well-being

– Economy’s total income
– Economy’s total expenditure
• Better healthcare
• Better educational systems
•…
– Measure ability to obtain many of the inputs
into a good life

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1. Gross Domestic Product
1.5 GDP - Good Measure of Economic Well-
being?
• GDP – not a perfect measure of well-being
– Doesn’t include
• Leisure
• Value of almost all activity that takes place
outside markets
• Quality of the environment
• Distribution of income

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2. Consumer Price Index
2.1 Definition
– Measure of the price level of goods & services
– Bought by a typical consumer
2.2 How the consumer price index is calculated
1. Fix the basket
2. Find the prices
3. Compute the basket’s cost
4. Chose a base year and compute the CPI

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Calculating the CPI and the inflation rate: an example
Step 1: Survey consumers to determine a fixed basket of goods
Basket = 4 hot dogs, 2 hamburgers
Step 2: Find the price of each good in each year
Year Price of hot dogs Price of hamburgers
2008 $1 $2
2009 2 3
2010 3 4
Step 3: Compute the cost of the basket of goods in each year
2008
2009
2010
Step 4: Choose one year as a base year (2008) and compute the CPI in each year
2008
2009
2010
Use the consumer price index to compute the inflation rate from previous year
2009
2010 23
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 FYI: What is in the CPI’s Basket?

17%
Transportation

15%
Food and 42%
beverages Housing

Education and
6%
communication 6%
6% 4% 4%

Medical care
Other goods
Recreation Apparel and services
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 FYI: Core CPI
(CPI – energy and food prices)

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 FYI: Measuring Inflation:
CPI vs. PCE Price Index
(Personal Consumption Expenditures Price Index )
 Homework
List 3 major problems in using CPI as a
measure of the cost of living. Explain and give
an example for each problem.

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 2. Consumer Price Index
2.3 The GDP deflator vs. consumer price index

GDP deflator CPI

Reflects prices of all goods & services.......... Reflects prices of goods & services...............

Compares the price of ..........................to Compares the price of ...............................to

the price of the same goods and services in the price of the basket in the base year
the base year
CPI vs. GDP deflator
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.

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 Figure 2 Two measures of inflation

This figure shows the inflation rate—the percentage change in the level of prices—
as measured by the GDP deflator and the consumer price index using annual data
since 1965. Notice that the two measures of inflation generally move together. 30
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 2. Consumer Price Index
2.4 Correcting variables for inflation
a. Comparing Dollar Figures from Different Times
• Inflation makes it harder to compare dollar amounts
from different times.
• Example: the minimum wage
– $1.15 in 1964
– $5.85 in 2007
• Did min wage have more purchasing power in
1964 or 2007?
• To compare, use CPI to convert 1964 figure into 2007’s
dollars…
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2. Consumer Price Index
Price level today
Amount in = Amount in ×
today’s dollars year T’s dollars Price level in year T

If CPI 1964 =100; CPI 2007=600

The minimum wage in 1964 was ............$ in 2007’s
dollars.

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2. Consumer Price Index
b. Real and nominal interest rates
• Nominal interest rate
– Interest rate as usually reported
– Without a correction for the effects of inflation
• Real interest rate
– Interest rate corrected for the effects of inflation
– = Nominal interest rate – Inflation rate

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 Figure 3: Real and nominal interest rates

This figure shows nominal and real interest rates using annual data since 1965. The nominal
interest rate is the rate on a 3-month Treasury bill. The real interest rate is the nominal
interest rate minus the inflation rate as measured by the consumer price index. Notice that
nominal and real interest rates often do not move together. 34
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