slide 0 CHAPTER 2 The Data of Macroeconomics

Chapter 2

The Data of Macroeconomics (Continued)

slide 1 CHAPTER 2 The Data of Macroeconomics

CPI and PPI

An index similar to CPI is the PPI (producer

price index) which measures the prices of a

typical basket of goods bought by firms rather

than consumers.

Both CPI and PPI are closely watched by

politicians to understand the state of the

economy. (www.tuik.gov)

slide 2 CHAPTER 2 The Data of Macroeconomics

Reasons why the CPI may overstate inflation

Substitution bias: The CPI uses fixed weights, so it

cannot reflect consumers’ ability to substitute toward

goods whose relative prices have fallen.

Example: Let’s continue with our typical consumer

who only consumes apples and oranges

Suppose that due to a major frost, orange production is

destroyed in a given year.

Quantity of oranges produced declines and the

price of oranges increases.

slide 3 CHAPTER 2 The Data of Macroeconomics

Recall that

The increase in the price of oranges will cause a

significant rise in the CPI in 2006 (and therefore the

inflation rate

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slide 4 CHAPTER 2 The Data of Macroeconomics

Wouldn’t we have the same problem if we calculated the

inflation rate based on the GDP deflator?

Because the QO2006 is very small, the increase in orange

prices will not inflate the GDP deflator as much.

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slide 5 CHAPTER 2 The Data of Macroeconomics

Reasons why

the CPI may overstate inflation

Introduction of new goods:

The introduction of new goods makes consumers

better off because you have more to choose from

This increases the real value of the dollar (it is as if

you are buying more with the same dollar).

But it does not reduce the CPI, because the CPI uses

fixed weights.

Whereas the GDP deflator includes any new goods

that is produced every year

slide 6 CHAPTER 2 The Data of Macroeconomics

Unmeasured changes in quality Suppose TUIK has been tracking the price of some specific brand of

cell phones for inclusion in the CPI.

At some date, the chosen variety of cell phone disappears from

store shelves, and in its place retailers start offering a new, higher

priced model with additional features.

How much of the difference in the prices of the new and old models

should be treated as a price increase, and how much reflects quality

improvement in the cell phone?

slide 7 CHAPTER 2 The Data of Macroeconomics

In constructing a measure of the change in the cost of

living, it is appropriate to exclude that part of the price

increase that results from improvements in the quality of

the good.

CPI overlooks this problem. Because it uses fixed

weights, it would treat the new model as a pricier version

of the old model and overstate the inflation.

The GDP deflator treats each new model as a

different product

slide 8 CHAPTER 2 The Data of Macroeconomics

CPI vs. GDP Deflator: Differences

The GDP deflator measures the prices of all

goods and services produced whereas the CPI

measures the prices of goods and services

bought by consumers only.

Examples:

Prices of capital goods are included in the GDP

(if they are produced domestically) such as

factories, machinery, tools, equipment

slide 9 CHAPTER 2 The Data of Macroeconomics

CPI vs. GDP Deflator

The GDP deflator includes only those goods

produced domestically whereas the CPI includes

imported consumer goods.

Example:

Increase in the price Korean noodles could

show up in Turkish CPI but not in the GDP

deflator.

slide 10 CHAPTER 2 The Data of Macroeconomics

CPI vs. GDP Deflator

The CPI assigns fixed weights to the prices of

different goods

Based on the quantities that a typical consumer

is believed to purchase (quantities produced in

a base year)

The GDP deflator assigns changing weights

Based on the quantities produced in each year

slide 11 CHAPTER 2 The Data of Macroeconomics

CPI vs. GDP Deflator

Laspeyres index is the general name for a price

index with a fixed basket of goods

such as the CPI

This type of an index with fixed weights tends to

overstate the cost of living

because it does not consider the fact that

people may substitute other goods for the

expensive good (i.e. the weights of each good

in the typical basket may change).

slide 12 CHAPTER 2 The Data of Macroeconomics

CPI vs. GDP Deflator

Paashe index is the general name for a price index with

a changing basket of goods

such as the GDP Deflator

This type of an index with changing weights tends to

understate the increase in cost of living

because even though people switch their preferences

(i.e. weights change) this may lead to a reduction in

welfare

Example: If you have to substitute apples for oranges

and you don’t necessarily enjoy consuming that many

apples...

slide 13 CHAPTER 2 The Data of Macroeconomics

Two measures of inflation in the U.S.

-3%

0%

3%

6%

9%

12%

15%

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

GDP deflator CPI

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slide 14 CHAPTER 2 The Data of Macroeconomics

Categories of the population

employed working at a paid job

unemployed not employed but looking for a job

labor force the amount of labor available for producing goods and services; all employed plus unemployed persons

not in the labor force not employed, not looking for work (e.g. a fulltime student, retired) If a person wants a job but no longer looks for a job,

he/she is a discouraged worker and not counted in the labor force.

slide 15 CHAPTER 2 The Data of Macroeconomics

Two important labor force

concepts

unemployment rate

percentage of the labor force that is unemployed

labor force participation rate

the fraction of the adult population that “participates” in

the labor force

100ForceLabor

unemployedofnumberRatentUnemployme

100PopulationAdult

ForceLaborLFPR

slide 16 CHAPTER 2 The Data of Macroeconomics

Exercise:

Compute labor force statistics

U.S. adult population by group, June 2006

Number employed = 144.4 million

Number unemployed = 7.0 million

Adult population = 228.8 million

Use the above data to calculate

the labor force

the number of people not in the labor force

the labor force participation rate

the unemployment rate

slide 17 CHAPTER 2 The Data of Macroeconomics

Answers:

data: E = 144.4, U = 7.0, POP = 228.8

labor force L = 151.4

not in labor force NILF = POP – L = 77.4

unemployment rate U/L = 4.6%

labor force participation rate L/POP = 66.2%

slide 18 CHAPTER 2 The Data of Macroeconomics

Okun’s Law

What type of a relationship should we expect to

find between the unemployment rate and the

real GDP?

Increases in the unemployment rate are

associated with decreases in the real GDP. This

relationship is called Okun’s law.

slide 19 CHAPTER 2 The Data of Macroeconomics

Case study: Turkish GDP

: GDP and its components

www.tuik.gov.tr

National accounts/Gross Domestic Product by

expenditure approach/

Statistical tables

CPI numbers

http://www.tcmb.gov.tr/

slide 20

End of Chapter Problem 6

Consider an economy that produces and

consumes bread and automobiles. In the

following table are data for two years

2000 2010

Q P Q P

Auto 100 $50,000 120 $60,000

Bread 500,000 $10 400,000 $20

CHAPTER 2 The Data of Macroeconomics

slide 21

a) Using 2000 as the base year, compute NGDP, RGDP,

the implicit price deflator for GDP, and CPI

b) How much have prices changed between 2000 and

2010? Compare the answers given by the Laspeyres

and Paasche price indexes. Explain the difference

c) Suppose you are a senetor writing a bill to index social

security and federal pensions. That is, your bill will

adjust these benefits to offset the changes in the costs

of living. Will you use the GDP deflator or the CPI?

Why?

CHAPTER 2 The Data of Macroeconomics

slide 22

a) NGDP(2000)=$10,000,000

NDGP (2010)=$15,200,000

RDGP (2010)=$10,000,000

GDP deflator=NGDP/RGDP=1.52

CHAPTER 2 The Data of Macroeconomics

slide 23

Cost of basket in 2000=NGDP (2000)

Cost of basket in 2010=$16,000,000

CPI=1.6

CHAPTER 2 The Data of Macroeconomics

slide 24

Problem 7

Abby consumes only apples. In year 1, red apples

cost $1 each, green apples cost $2 each, and

Abby buys 10 red apples. In year 2, red apples

cost $2, green apples cost $1, and Abby buys 10

green apples.

a) Compute a CPI for apples for each year.

Assume that year 1 is the base year in which the

consumer basket is fixed. How does your index

change from year 1 to year 2?

CHAPTER 2 The Data of Macroeconomics

slide 25

b) Compute Abby’s nominal spending on apples in each

year. How does it change from year 1 to year 2?

c) Using year 1 as the base year, compute Abby’s real

spending on apples in each year. How does it change from

year 1 to year 2?

d) Defining the implicit price deflator as the nominal

spending divided by real spending, compute the deflator for

each year. How does the deflator change from year 1 to

year 2?

CHAPTER 2 The Data of Macroeconomics

slide 26

e) Suppose that Abby is equally happy eating red

or green apples. How much has the true cost of

living increased for Abby? Compare this answer to

your answers to parts (a) and (d). What does this

example tell you about Laspeyres and Paasche

indexes?

CHAPTER 2 The Data of Macroeconomics