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Aggregate: Price LevelMeasured using a Price Index

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What is a

priceindex?

Distinguish between Nominal and RealGDP.

Nominal GDP:Measured using current $ prices:

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)( current PQ2

Real GDP:Measured using base year $ prices; that is,prices that are fixed at a chosen base year level

Shows how the economys overall real real productionof goods & services changes over time.

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)( basePQ3

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All Goods and Services Produced in the Current Year

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Valued at base yearprices = RealGDP

Valued at currentyear prices =Nominal GDP

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(1) (2) (3) (4) (5) (6)

ProductQuantitiesin marketbasket in

2005

Prices of2005

marketbasket in

2005

Expenditureson 2005market

basket in2005

Prices of2005 market

basket in2000 prices(base year)

Expenditureson 2005

market basketin 2005 prices

(3) X (2) (5) X (2)Pizzas 2 $12 $24 $5 $10Robots 1 $18 $18 $20 $20

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enc sCDs 1 $14 $14 $14 $14

TOTAL $64 $50

Nominal

GDP

Real

GDP 5

Real GDP:constant base year prices provide thebasis for comparing real quantities(output) in different years.

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From nominal GDP & real GDP we can

Calculation of a price index that isused to measure the overall pricelevel

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compute a

Price index: GDP Deflator

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GDP Deflator & the Price Level

The GDP Deflator compares Real and Nominal GDPfor the same year

any rise in nominal GDP is attributable to arise in the price level since quantities stay the same

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the GDP Deflator compares the current levelof prices to the level of prices in a base period

(only the prices are different in calculating nominal &real GDP in 05)

' 00yr base

' 05

' 0505 100

GDPrealGDPno m

defl at or GDP =

The GDP Deflator

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a price level change is reflected by the GDP deflatorprice index and the GDP deflator can be used tomonitor changes in the overall level of prices in theeconomy

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By convention the ratio formed in the calculation ofthe GDP deflator is multiplied by 100 for ease of use

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1281005064 ==

For example:

GDP deflator 05, 2000=100

NominalGDP

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i.e. the price level rose 28% from 2000 to 2005

In General a Price Indexcompares the $ value of some market basketof goods & services in a specific or current

eriod

Summary

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to the $ value of an identical market basket ina reference or base period

the GDP deflator is a price index

100

=

prices year baseat

output pricescurrent at output

current of total

r GDPdeflato same of cost $ total

cost $

GDP Deflator: is an Implicit Price Index

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note GDP deflator and a price index in general= 100 in the base year.

100)Q(P)Q(P

deflatorGDP'05'00

'05'05'05

=

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Recent Updates: GDP DeflatorIn May of 2001, Statistics Canada adopted amore complicated method for calculating Real

GDP: chain Fisher method. This results in aGDP deflator which is less sensitive to theparticular base year chosen.

e mp c a n r c e n ex orm o edeflator is set at 100 for the first quarter of 1997and then changes continuously.

www.statcan.ca and search for chain Fisher

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Calculation of the Inflation Rate Using theGDP Deflator

1

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Yr PI Yr PI Yr Index Price

Rate Inflation =

inflation 28% 100

100 128 ==

Adjusting GDP for Changes in the Price Level

100

deflator GDP

GDP nominal GDP Real =

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The Consumer Price IndexRelevant to all who earn an income

Measures the overall price level for consumer goodsby comparing the $ value of a fixed basket of

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given year with the $ value of the same basket in thebase year

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Current CPI Weights & Base Period

About 600 commodities chosen for the CPI

basket are weighted according to their relativeimportance in the total expenditures of consumers

CPI commodities and their relative im ortance are

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determined on the basis of surveys conductedevery ten or fewer years. The current weightswere introduced in 2005.

The current base period is 2002=100

www.statcan.ca/english/sdds/2301.htm

Constructing and Calculating a SimpleCPI1. Determine the market basket contents and the

base year.2. Find prices for the items in the basket both in the

base year and the current year.3. Find the $ value of the basket in the base ear

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and the current year.

Now calculate the CPI

Calculate a Simple CPIUnion of University Provinces

Good 2000 2000Qn P

$

2001 2001Qn P

$

2002 2002Qn P

$

Books 10$50 12.$50 100....$60

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enc sPens 100$ 5 .50..$10 .. .20..$20

CPI 2002 (base year 2000)Bottom 2000 Q's x 2000 P's = $1100Top 2000 Qs x 2002 Ps = $2750

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Calculating a Simple CPI

100)Q(P

)Q(PCPI

basketyrbaseyrbase

basketyrbasecurrent

=

100x

=)Q(P

CPIbasket0002

02

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$50 x 10 = $500$1.00 x 100 = $100

$5 x 100 = $500P 00 x Q00

$1100

$60 x10 = $600$1.50 x100 = $150

$20 x100 = $2000P 02 x Q00

$2750

)Q(P basket0000

Calculating a Simple CPI

= 250 (Base year 00 = 100)

100$1100$2750CPI02 =

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One more major price index is calculated: PPI(producer price index) market basket of goods &

services bought by firms.

note CPI= 100 in the base year.

1. Substitution biasConsumers respond to relative price changes bybuying more of the relatively cheap goods Index overstates inflation

Problems in Measuring CPI

2. Introduction of new goods Index overstates inflation

3. Unmeasured quality change. Index overstates inflation

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Inflation in Canada

22http://www.bankofcanada.ca/en/inflation_calc.htm

The Consumer Price Indexthe inflation rate is high when the price level isrising rapidly and low when the price level isrising slowly.

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1. Tool for deflating current dollar estimates toobtain constant dollar estimates that eliminatethe effects of price change over time

The CPI Used in Four Specific Ways

Constant $ Estimates:Using the CPI to compare $ values over time

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e.g. price of a tin of butterscotch candies was$.45 in 1978 and $1.00 in 2008.

In 2008 $s, how much would you pay for thecandies? What would be the purchasing power ofyour 2008 $s in 1978?

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SupposeCPI baseyr.02 in 1978= 37.6

CPI 2002=100 in 2008 = 114.5

Value in

2008 $s of

= Price19782008

2002__ year BaseCPI

25Candy was more in 1978.

$1.37

$0.4537.6

114.5

=

=

1978 Price2002__ year Base

2. Escalate a given dollar value over time topreserve the purchasing power of that value

Adjust contracted payments such as wages, rents,leases, child support: private and public pensionprograms, personal income tax deductions

The CPI Used in Four Specific Ways

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Use the CPI to Compare $ Values Over Time

Annual family expenses

Current $CPI

2002 = 100 Constant 2002, $s

Nominal Real

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100yearcurrent""forCPI

$Currents$'2002,constant =

1997 $20,000 90.5 $22,099

2000 $25,000 96.6 $25,879

2004 $30,000 105.6 $28,409

2007 $35,000 111.9 $31,278

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Use the CPI to adjust payments over time e.g. Divorce Agreement

The basic child support payment is$600/month effective May 1, 2003. EveryMay 1 thereafter, payments will be adjustedby the percentage change over 12 months inthe March CPI for Canada.

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Suppose the CPI increased 2.2% in the first year,1.4% in the second.

On May 1, 2004, payment increases by2.2% x $600 = $13.20

On May 1, 2005, payment increases by1.4% x $613.20 = $8.58

Interest: payment of money income in the future for atransfer of money in the past.

Interest rate paid by the bank

3. Real & Nominal Interest Rates

The CPI Used in Four Specific Ways

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.Interest rate corrected for inflation

real real rate of interest.

real interest rate =nominal interest rate inflation rate.

The CPI Used in Four Specific Ways

4. Setting and evaluating economic policies Bank of Canada uses the CPI to evaluate

its policies Economic analysis and research

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Inflation

Inflation is a process of rising prices.

We measure the inflation rate as thepercentage change in the average

.Why do we care about inflation?

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Inflation erodes the purchasing power ofmoney?????

Costs of Inflation

A fall in purchasing power of money?

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.

Inflation of prices goes hand inhand with inflation of incomes.

Costs of Inflation

1. Inflation Tax: shoe leather costsInflation is like a tax imposed on everyonewho holds money.

.

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2. Menu costsUpdating price lists & posted prices;printing new menus, catalogues, etc.

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3. Increased variability of relative pricescauses reduced efficiency of the pricesystem.Confusion & Inconvenience

*Serious Costs ofInflation

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4. Hyperinflation and economic breakdown

5. Special costs associated withunexpected inflation

Costs of Inflation

Unexpected inflation leads to a randomredistribution of income having nothing to dowith merit or need.

for debtors who ain at the ex ense of

*Serious Cost of Inflation

creditors for people on fixed incomes for those workers whose wages dont keep

up with inflation.

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