The Measurement and Structure of the National Economy

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The Measurement and Structure of the National
Economy
Part II
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Overview

• Nominal vs. Real Variables
• Real GDP
• Price Indexes and Inflation
• Interest Rates

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Nominal vs. Real Variables

• Current (market) vs. Constant Prices
• Base year
• All of the macroeconomic variables discussed can
  be expressed as real variables.
• Using real variables allows us to measure changes
  in the quantity of variables.

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Real vs. Nominal Changes Example 1 Suppose that
the North Bay Canadian Tire sold 1600 vacuums in
2004 at a price of 89 each. Sales Revenue
89x1600 142,400 In 2005, they sold 1750
vacuums at a price of 96 each. Sales Revenue
96x1750 168,000 Between 2004 and 2005, sales
revenue increased by 18.
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Actual vacuum sales increased by 9.4
Example 2 Suppose that the economy of Valentinia
produces 3 commodities greeting cards, roses
and chocolate.
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Nominal GDP in 2004 (1500x3) (1350x48)
(1960x5.50) 80,080
Nominal GDP in 2005 (1800x3.20) (1260x50)
(2000x6) 80,760
Measured GDP increased by 0.8. How much of that
increase is from an increase in output and how
much is attributable to an increase in prices?
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Real GDP (constant-dollar GDP)

• Nominal GDP (current-dollar GDP) uses market
  prices, but market prices change over time. This
  presents a problem for economists.
• In order to measure changes in output, real GDP
  is used.
• Changes in output are measured by using the
  prices from a given year the base year.

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Example 2 Continued Using 2004 as the base
year Real GDP in 2004 (1500x3) (1350x48)
(1960x5.50) 80,080 Real GDP in 2005
(1800x3) (1260x48) (2000x5.50)
76,880 Real GDP declined by 4 in 2005.
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It matters which base year you choose. Using 2005
as the base year Real GDP in 2004 (1500x3.20)
(1350x50) (1960x6) 84,060 Real GDP in
2005 (1800x3.20) (1260x50) (2000x6)
80,760 Real GDP fell by 3.9 in 2005.
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Price Indexes and Inflation

• A price index is a measure of the average level
  of prices for some specified set of goods and
  services relative to the prices in a specified
  base year.
• GDP deflator the ratio of nominal GDP to
  current GDP
• GDP deflator Nominal GDP
• Real GDP

X 100
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So using Example 2, GDP deflator for 2005 (using
2004 as the base year) is GDP deflator 80,760
1.05 76,880 The overall level of
prices in Valentinia are 5 higher in 2005 than
in 2004.
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Consumer Price Index (CPI)

• The CPI measures how much the price of a basket
  of goods and services (chosen to be
  representative of a typical households expenses)
  changes over time.
• The GDP deflator measures the average level of
  prices of goods and services included in GDP.
• For each year, the current prices of a fixed
  basket of consumer goods and services is
  collected and compared to prices of these goods
  and services in the base year.

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Price of i in base year
Quantity of i in base year
Price of i in current year
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Fixed vs. Variable Weight

• Chain-weighted Price Index
• Variable weight the weight given to a
  particular good in the price index may change
  from period to period.
• Fixed weight the weights on each good are
  fixed. The basket assumes that in a given period
  a typical household consumes the same proportion
  of each good.

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Issues with the CPI

• Quality-adjustment bias an increase in the
  price of a good may also reflect improvements in
  the quality of that good.
• Substitution bias households change their
  consumption patterns in response to price
  changes.

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For the most part, the issues with the CPI boil
down to the normative vs. positive role of the
measure. Positively, the CPI measures the rate of
change of prices for a fixed basket of goods.
Normatively, people believe that it measures the
change in the cost for the same standard of
living.
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Inflation

• The percentage rate of increase in the price
  index per period.

Price index in period t.
Price index in period t1.
Change in price index.
Rate of inflation between t and t1.
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Canadian Inflation Rate 1951-2001
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Interest Rates

• Interest rate is the price of borrowing funds. It
  measures the rate at which the nominal value of
  an interest-bearing asset increases over time.
• If we want to know how the value of the asset
  changes in terms of purchasing-power over time,
  we need to account for the loss of purchasing
  power due to inflation.
• The nominal interest rate compensated the holder
  of the asset for forgone current consumption,
  risk and the effects of inflation.

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The real interest rate of an asset is the rate at
which the value of the asset increases over time
in terms of purchasing power.
Nominal interest rate
Real interest rate
Rate of inflation
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Canadian Nominal and Real Interest Rates
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Expected Real Interest Rate
Nominal interest rate
Real interest rate
Expected rate of inflation