Economics 121 Principles of Macroeconomics Foundations: Macroeconomic Fundamentals

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1 Economics 121 Principles of Macroeconomics Foundations: Macroeconomic Fundamentals Dennis C. Plott University of Illinois at Chicago Department of Economics Summer 2015 Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

2 Goals of This Section Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Over the course of the semester, we will explore many aspects of the economy, including how all of the elements relate to one another. For this section, we have a less lofty goal: to figure out how to measure the total output of an economy. Being able to measure total output is incredibly important, since much of macroeconomics depends on our ability to measure and predict aggregate economic activity. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

3 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Measuring Total Production: Gross Domestic The most common measure used by economists of overall economic activity in an economy is gross domestic product, or GDP. Gross domestic product (GDP): the market value of all final goods and services produced in a country during a period of time, typically one year or quarter. We will examine each of the parts of this definition in turn. Why Do We Care? Because output is highly correlated (at certain times) with things we care about (standard of living, wages, unemployment, inflation, budget and trade deficits, value of currency, etc.) Who Measures GDP? The Bureau of Economic Analysis (BEA) ( GDP is reported quarterly and annually, although there are monthly revisions as late as years after the initial reports. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

4 Gross Domestic Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income... market value... We cannot add together the number of cars, melons, haircuts, and all other goods and services without agreeing on a common way to measure them. The best practical way is to value each good and service in monetary terms; and the best measure of this that we have is the price that each good or service is sold for.... final goods and services... A final good or service is a good or service purchased by a final user. These are what are used to calculate GDP. Why? If we counted intermediate goods and services as well, ones that were inputs into another good or service, then we would end up double-counting. Example: if we counted the value of the ice cream bought by a grocery store, and also counted the value of that ice cream when it was sold to a consumer, we would be double-counting the wholesale value of the ice cream. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

5 Gross Domestic Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income... during a period of time... To measure total output in a given year (quarter), we measure the goods and services produced only in that given year (quarter). Again, this avoids double-counting: if you buy a DVD in 2014, that DVD counts in 2014 s GDP. If you resell it in 2015, it will not count again in So GDP counts only new goods and services. Used items were previously produced and counted, so don t need to be counted again. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

6 Production and Income Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income There are two main conceptual ways to measure the total economic activity in an economy: total production or total income. When we measure one, we are also measuring the other. Why? Everything that is produced and sold constitutes income for someone; so we have the choice of measuring the value of products produced and sold, or the value of incomes, and each is a valid way of measuring economic activity. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

7 Follow the Spending to Measure GDP Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income To measure GDP, the Bureau of Economic Analysis (BEA) in the Department of Commerce measures four major categories of expenditures: Personal Consumption Expenditures, or Consumption (C) Gross Private Domestic Investment, or Investment (I) Government Consumption and Gross Investment, or Government Purchases (G) Net Exports of Goods and Services, or Net Exports (NX) GDP can be expressed as the sum of these: Y = C + I + G + NX We will examine each component of GDP in turn. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

8 Consumption Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Consumption is spending by households on goods and services, not including spending on new houses (which are counted instead in investment). In BEA statistics, consumption is further divided into expenditure on services, durable goods, and non-durable goods. The Sum of Durables (lasting three years or more), Non-Durables, and Services Purchased Domestically by Non-Businesses and Non-Governments (i.e., individual consumers). Includes Haircuts (services), Refrigerators (durables), and Apples (non-durables). Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

9 Investment Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Investment is spending by firms on new factories, office buildings, and additions to inventories, plus spending by households and firms on new houses. The BEA measures the following categories of investment: business fixed investment, residential investment, and changes in business inventories. Includes: This last category includes goods that have been produced but not yet sold. All final purchases of machinery, equipment, and tools by businesses. All construction (including residential structures). Changes in business inventory. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

10 Investment (Continued) Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Excludes intermediate goods (i.e., goods used-up during production in the same period that they themselves were produced note the difference with equipment/capital goods which last for several periods). Land purchases are NOT counted as part of GDP (land is not produced!) Stock purchases are NOT counted as part of GDP (stock transactions do NOT represent production they are saving. More on saving later.) Important: There is a difference between financial and economic investment! Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

11 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Adding More of Lady Gaga to GDP The BEA continually studies ways to improve its measurement of GDP. In 2013, the BEA started counting R&D as investment, rather than an intermediate good, so as to emphasize the importance of intellectual property. A consequence is that money spent on development of, say, entertainment products, now gets counted as investment. So the money spent by Lady Gaga and her record company on writing and recording her songs is now included in the investment component of GDP. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

12 Government Purchases Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Government purchases are spending by federal, state, and local governments on goods and services, such as teachers salaries, highways, and aircraft carriers. For the U.S., state and local levels (police and fire protection, school teachers, snow plowing) and the federal level (President, Missiles). This does not include transfer payments, since those do not result in immediate production of new goods and services. Transfers are defined as the exchange of economic resources from one economic agent to another when no goods or services are exchanged. Examples of transfer payments: Welfare and Social Security Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

13 Net Exports Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Net exports are defined as the value of exports minus the value of imports. This difference might be positive or negative; in recent years, this has been negative in the United States. Since we want to count domestic production (production in the United States), we add up the value of the goods and services sold to foreigners, and subtract off the value of the goods and services sold to Americans by foreigners. Net Exports (NX): Exports (EX) Imports (IM); Exports: The Amount of Domestically Produced Goods Sold on Foreign Soil Imports: The Amount of Goods Produced on Foreign Soil Purchased Domestically. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

14 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Simple Examples Suppose I produce tablets; e.g., an iwhatever. If so, I could: sell it to some domestic customer (Consumption) sell it some business (Investment) keep it in my stock room as inventory (Investment) sell it to the city of Chicago to use in their offices (Government spending) sell it to some foreign customer (Export) Only include expenditures for goods that are newly produced. If I give $10 to a movie theater to watch a movie, it is counted as expenditure. If I give $10 to my nephew for a birthday present, it is not counted as expenditure. If I give $10 to the ATM machine to put in my savings account, it is not counted as expenditure. The second example would be considered a transfer (once I give $10 to my nephew, he can go to the movies if he wanted to once that $10 is spent, it will show up in GDP). The third example is considered saving (I am delaying expenditure until the future). Once I spend the $10 future GDP in the future, it will show up in GDP. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

15 Components of GDP in 2012 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Consumption is the largest component of GDP; within that, services are the largest component almost half of GDP. American net exports are negative, since the value of our imports exceeds the value of our exports. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

16 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

17 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Some Examples of GDP Calculations If the following transactions took place in 2015 which would count toward GDP for 2015? Social security payments received by a retired factory worker. The purchase of an insurance policy. The sale of brand new tires. A Boeing 777 commercial airplane is constructed in Everett, Washington, but needs tests flights before delivery as of 31 st December A newly married couple purchases a newly constructed house. A house constructed in 2010 is sold again in January Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

18 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Measuring GDP Using the Value-Added Method An alternative method to measure GDP is to measure the value added: the market value a firm adds to a product. The final selling price of a product must equal the sum of the values added to the product at each stage of production. The table below illustrates this method for a shirt sold on L.L.Bean s web site. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

19 Using Value Added to Measure the True Size of Wal-Mart Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income How can we use economic analysis to compare the size of a major corporation to the size of a country? During 2008, Wal-Mart s sales were approximately $374 billion, nearly 2.6 percent of U.S. GDP. Some social commentators might want to measure the impact of Wal-Mart just through its sales. But to produce those sales, Wal-Mart had to buy goods from many other companies. Based on Wal-Mart s annual reports, its cost of sales was $286 billion, leaving approximately $88 billion in value added. If we used Wal-Mart s sales to compare it to a country, it would have a GDP similar to that of Belgium, which is ranked 28 th in the world. However, using the more appropriate measure of value added, Wal-Mart s size is closer to Bulgaria, ranked 56 th in the world. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

20 Expenditure Equals Income : A Simple Example Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income What buyers spend (expenditure) equals what sellers receive (income) Suppose I sell a glass of lemonade for $1.00 I just use lemons, sugar, and water to make the lemonade. The water costs $0.01 per glass, the sugar costs $0.09 per glass, and the lemons costs $0.20 per glass. Income/Profit for me is $0.70 The same procedure is used for the people who sell water ($0.01 of income), for the people who sell the sugar ($0.09 of income), and for the people who sell the lemons ($0.20 per glass). The $1.00 spent on a glass of lemonade resulted in $1.00 worth of income for various people (the $1.00 ended up in someone s pocket). Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

21 Calculating Real GDP Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Since GDP is measured in value terms, we might have problems interpreting changes over time if prices change. Is an increase in GDP due to production increasing, or due to prices increasing? To separate these effects, the BEA calculates both nominal GDP the value of final goods and services evaluated at current-year prices and real GDP the value of final goods and services evaluated at base-year prices. The choice of a base-year is arbitrary; we might use any year s prices to compare real GDP in each year. The current standard is Unfortunately, the relative prices also change from year to year, distorting real GDP calculations. Since 1996, the BEA has overcome this problem by using chain-weighted prices, using previous-year prices to adjust current-year production measure. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

22 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Calculating Real GDP: An Example The table shows output and prices in 2009 and Calculating the total value of output in 2009 gives: $ $990 + $1350 = $5540. To calculate real GDP in 2015, we use the prices from This gives real 2015 GDP in 2009 dollars of $6680. Most prices increased from 2009 to 2015, so using nominal GDP would have yielded a higher figure: $7800. This highlights the need to use real GDP to avoid exaggerating growth. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

23 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Comparing Real GDP and Nominal GDP The current base year for calculating prices is 2009, so real and nominal GDP are equal in Growth figures reported in the media are the growth in real GDP. Since prices have generally increased since 2009, real GDP is less than nominal GDP, and the opposite is true before Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

24 The GDP Deflator Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Economists and policy-makers are interested in the price level: a measure of the average prices of goods and services in the economy. Why? Stable prices are desirable because they allow households and firms to plan for the future appropriately. In order to know whether we are achieving price stability, we need to measure the price level. One way to do this is using the GDP deflator: a measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100: Nominal GDP GDP deflator = 100 Real GDP Since nominal and real GDP will be the same in the base year, the GDP deflator will be 100 in the base year. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

25 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Calculating the GDP Deflator The table below gives the values of nominal and real GDP for 2011 and Other Measures of Total Production and Total Income We can use this to calculate the GDP deflator in each year: The GDP deflator increased from 103 to 105 between the two years. This is a 1.9% increase: ( ) 100 = 1.9% So we say the price level rose 1.9% over this period. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

26 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Shortcomings of GDP What GDP Is NOT GDP can be a useful tool to measure total output in an economy. Many people go further than this, interpreting GDP as a measure of the well-being of citizens. However GDP has shortcomings, both in its measure of total production, and in its usefulness as a measure of well-being. GDP is not, or never claims to be, an absolute measure of well-being Size effects (Population): But even GDP per capita is not a perfect measure of welfare The gross national product does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud to be Americans. U.S. Senator Robert F. Kennedy, 1968 Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

27 Shortcomings of GDP as a Measure of Total Production Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Two important types of production are omitted from the BEA s measurement of GDP: 1. Household Production Household production such as childcare, cleaning, and cooking is not typically paid for with money. However such contributions are real if they were performed by a non-household-member, they would be paid for and counted in GDP. 2. The Underground Economy Buying and selling of goods and services might be concealed from the government to avoid taxes or regulations, or because the goods and services are illegal. This constitutes the underground economy. This is estimated to be approximately 10% of the economy in America, and substantially more in low-income households. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

28 How Important Are These Shortcomings? Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income If we are comparing GDP from year to year, the size of household production and the underground economy is probably about the same from year to year, so GDP growth is a reasonable measure of the growth in total production. However over long periods of time, these shortcomings might be more serious. Example: As women have entered the workforce in larger numbers, some household production has been replaced by paid childcare and restaurant meals. So increases in GDP may exaggerate the increase in actual total production. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

29 Underground Economies in Developing Countries Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income In developing countries, the underground economy is often referred to as the informal sector, as opposed to the formal sector, in which output of goods and services is measured. In many developing countries, the informal sector is very large; often above 50% of total output. Economists studying economic development say this often reflects poor government policies: high taxes and regulations and low confidence in the security of private property from government seizure. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

30 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Shortcomings of GDP as a Measure of Well-Being GDP per capita (i.e., GDP divided by population) is often used to represent differences in standards of living from country to country. However, even if it accurately measured total production, it would not reflect: The value of leisure or increased product quality GDP and the environment pollution and other negative effects of production Resource depletion and the harmful effects of pollution are not deducted from GDP (oil spills, increased incidence of cancer, destruction of habitat for wildlife, the loss of a clear unobstructed view). GDP does include payments made for cleaning up the oil spills, and the cost of health care for the cancer victim. Crime and other social problems The distribution of income In fact, improvements in many of these will result in lower GDP per capita. Example: Lower crime would allow lower spending on police, prisons, and private security. This would decrease GDP, but surely result in improvements in economic well-being. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

31 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Did World War II Bring Prosperity? World War II was a period of extraordinary sacrifice and achievement by the greatest generation. But statistics on GDP may give a misleading indication of whether it was also a period of prosperity: Production was very high, but much of the production was of military goods so people weren t becoming more well-off. After the war, GDP fell; but the production of consumption goods rose rapidly. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

32 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income National Income and Product Accounts (NIPA) The BEA is charged with performing national income accounting for the United States. Each quarter, it publishes the National Income and Product Accounts tables. These include GDP computations, but also: Gross National Product (GNP): Production performed by citizens of a nation, including overseas production (as opposed to GDP, which is performed within national borders) Example: A new Mercedes-Benz M-Class (SUV) made in Alabama is counted toward U.S. GDP, but Germany s GNP. The difference between GNP and GDP is small for the United States, about 0.2%, but higher for countries that have many citizens working abroad; e.g., the Philippines National Income: GDP minus the consumption of fixed capital; i.e., GDP minus depreciation Personal Income: Income received by households; includes transfer payments, but excludes firms retained earnings Disposable Personal Income: Personal income minus personal tax payments; this measures the amount that households are able to spend or save Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

33 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income NIPA Measurements The graph below shows the various measures of the national income accounts for the United States in National income must be smaller than GDP, since it is just GDP minus depreciation. Similarly, disposable personal income must be less than personal income, since it is just personal income minus taxes. Each measure is useful in different contexts. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

34 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Total Production = Total Income All production must be rewarded with income; so in theory, we could count either in order to calculate GDP. In practice, data limitations make us unlikely to come up with the same number; there will always be some statistical discrepancy. The figure illustrates the division of income as measured by the BEA in Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

35 Simon Kuznets ( ) Nobel Prize 1971 Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Simon Kuznets provided the methodology for modern national-income accounting and developed the first reliable national-income measures for the United States. Kuznets is often referred to as the "father of national-income accounting". A native Russian, he immigrated to the United States at the age of 21 and spent his academic career teaching at the University of Pennsylvania, Johns Hopkins University, and Harvard University. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

36 Common Misconceptions to Avoid Calculating GDP Nominal versus Real GDP Limitations and Criticisms of GDP Other Measures of Total Production and Total Income Investment in reference to national income accounting has a very narrow definition: purchases of things like machines, factories, and houses. It refers only to the purchase of new items, not trades in financial instruments based on those items. We based statements about growth on GDP; but GDP has limitations, both as a measure of total production, and as a measure of well-being. In order to make useful comparisons, concentrate on real GDP rather than nominal GDP. In calculating real GDP, the choice of base year is largely arbitrary; there is no correct base year. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

37 Measuring Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Last section, we learned about how to measure total output a critical first step in understanding the economy. In this section, we continue along these lines, learning about how to measure inflation. This is a very important and commonly-used macroeconomic concept; we want to solidify what it means, so that we can talk intelligently about it. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

38 Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates Price Level and Rate Price level: a measure of the average prices of goods and services in the economy. The Costs of Hyperinflation We refer to the percentage increase in the price level (P) from one year to the next as the inflation rate (π). π = P t P t 1 P t Last section we used the GDP deflator to measure changes in the price level. By measuring changes in the prices of different baskets of goods, we would come up with different measures. Two commonly-used measures are: 1. The consumer price index (CPI) 2. The producer price index (PPI) We will examine each in turn. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

39 , Deflation, and Disinflation Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation is a rise in the general level of prices of goods and services in an economy over a period of time. Disinflation is a decrease in the rate of inflation a slowdown in the rate of increase of the general price level of goods and services over a period of time. For example if the annual inflation rate for the month of January is 5% and it is 4% in the month of February, the prices disinflated by 1% but are still increasing at a 4% annual rate. Deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0%. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

40 Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Consumer Price Index (CPI) Consumer price index (CPI): a measure of the average change over time in the prices a typical urban family of four pays for the goods and services they purchase. The chart shows the composition of the basket of goods used to create the CPI. This basket of goods derives from a survey of 14,000 households by the BLS. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

41 Measuring Calculating the CPI Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation To calculate the CPI in a given year, we need: A basket of goods The cost to purchase the basket of goods in a base year The prices in the current year The CPI in the current year is the cost to purchase the basket of goods this year, divided by the cost in the base year. By convention, we multiply this by 100, so that the CPI in the base year is 100. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

42 A Simple CPI Calculation Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation The table above gives the information we need to create the CPI in 2014 and 2015, using the basket of goods from Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

43 Measuring A Simple CPI Calculation (Continued) Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Based on these data, the inflation rate from 2014 to 2015 is the percentage change in the CPI: = 1.7% 120 Since the CPI measures consumer prices, it is often referred to as the cost-of-living index. CPI-inflation is sometimes used to generate fair increases in wages for workers, and government benefits. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

44 Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Is the CPI an Accurate Measure of? Some potential problems with the CPI include: Substitution bias: Consumers may change their purchasing habits away from goods that have increased in price. Increase in quality bias: Products like cars and computers have become more durable and better quality over time. It is hard to isolate the pure-inflation part of price increases. New product bias: The basket of goods changes only every 10 years. There is a delay to including new goods like cell phones. Outlet bias: Increases in purchases from discount stores like Sam s Club and Costco or the internet are not incorporated into the CPI; it still uses full-retail price. For these reasons, economists believe the CPI overstates true inflation by 0.5 to 1 percentage point. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

45 Producer Price Index (PPI) Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Producer price index (PPI): an average of the prices received by producers of goods and services at all stages of the production process. It is conceptually similar to the CPI, in that it uses a basket of goods, but the goods are those used by producers. The PPI can give early warning of future movements in consumer prices. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

46 Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Using Price Indexes to Adjust Prices Suppose your mother received a salary of $25,000 in This would have bought much more than a salary of $25,000 in We can use the CPI to estimate the purchasing power of that $25,000 in 2012 dollars: CPI in 2012 Value in 2012 Dollars = Value in 1987 Dollars ( ) CPI in = $25, $50,000 So $25,000 in 1987 would have bought about as much as $50,000 in Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

47 Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Nominal and Real Values The current standard base year for the CPI is an average of prices. Values like wages in current-year dollars are called nominal variables. When we adjust them for inflation, by dividing by the current year s price index and multiplying by 100, we convert them to real variables. Example: Caterpillar employees signed a contract freezing wages until How much less will their wages be worth then? If the CPI rises to 260, then Caterpillar employees will receive a real wage decrease of: ( $10.38 $11.59 $11.59 ) 100 = 10.4% Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

48 Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation and Interest Rates When you lend money to someone, they typically agree to pay you back with interest. If the interest rate is 6%, for example, then a $1,000 loan paid back in a year will be paid back with $1,060. This 6% is the nominal interest rate: the stated interest rate on a loan. But in that year s time, prices will have risen; so the $1,060 next year is not worth the same as $1,060 this year. We can adjust for inflation by calculating the real interest rate, equal to the nominal interest rate minus the inflation rate. (Note: this is an approximation, but it is quite accurate for low interest and inflation rates.) i r + π (Fisher Equation) If prices rise by 2% from this year to next, then your real interest rate on the loan is only 4%. This more accurately reflects the cost of borrowing and lending money. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

49 Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Nominal interest rate (i): the return to saving and the cost of borrowing without adjustment for inflation. Real interest rate (r): the return to saving and the cost of borrowing after adjustment for inflation. How are the nominal and real interest rates related? The Fisher equation: i = r + π The equation written in this way is called the Fisher equation, after economist Irving Fisher. It shows that the nominal interest rate can change for two reasons: because the real interest rate changes or because the inflation rate changes. There are two versions of the Fisher equation: Ex ante ( before the fact ): i = r e + π e ; i.e. chosen before know, uncertain Ex post ( after the fact ): i = r + π; i.e. no uncertainty, determined or known Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

50 Irving Fisher ( ) Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Fisher was an American (mathematical) economist with a well deserved reputation for clear exposition. He contributed a great deal to the field of economics including modernizing the quantity theory of money, the Fisher equation, Fisher effect, and he was a pioneer in the construction and use of price indexes. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

51 Measuring Common Interest Rates Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Federal funds rate: the interest rate that the banks charge each other on overnight loans. 1 The London Interbank Offered Rate (LIBOR) is the most active interest rate market in the world. It is determined by rates that banks participating in the London money market offer each other for short-term deposits Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

52 Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Common Interest Rates (Continued) The prime interest rate is the interest rate charged by banks to their most creditworthy customers (usually the most prominent and stable business customers). The prime rate is a benchmark that banks often use in quoting interest rates to all of their customers. For example, a less well-known firm might be quoted a rate of "prime plus three-fourths", which means that if the prime rate is, say, 10%, the firm would have to pay interest of 10.75%. The prime rate depends on the cost of funds to the bank; it moves up and down with changes in the economy. 3 The three-month U.S. Treasury bill (T-Bill) Rate is probably the most widely followed short-term interest rate. The interest rate on U.S. Treasury bonds (T-Bond) with ten years to maturity is probably the most widely followed long-term interest rate since it is a general indicator of long-term interest rate movements Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

53 Why We Care About Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation An example of how inflation can affect real returns. Suppose you and I agree that a real rate of 0.05 over the next year is fair. borrowing rate, salary growth rate, etc. Suppose we also agree that expected inflation over the next year is 0.07 We should then set the nominal return equal to 0.12 (i = r e + π e ) Summary: i = 0.12 r e = 0.05 π e = 0.07 Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

54 Measuring Why We Care About (Continued) Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Suppose that actual inflation is 0.10 (π > π e ) In this case, r = 0.02 (r = i π) Borrowers/Firms are better-off Lenders/Workers worse-off Suppose that actual inflation is 0.03 (π < π e ) In this case, r = 0.09 (r = i π) Borrowers/Firms are worse off Lenders/Workers better off Research has also shown that higher inflation rates are correlated with more variability. People/firms do NOT like the uncertainty; i.e. they are risk adverse. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

55 Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation U.S. Nominal and Real Interest Rates The chart shows the interest rate on three-month treasury-bills, a good measure of the nominal interest rate. The real interest rate adjusts them for changes in the CPI. Notice that in 2009, the real interest rate was above the nominal interest rate. This was because the change in the CPI was negative then, indicating a rare deflation, or decrease in the price level. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

56 Measuring Is a Problem? Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Sometimes inflation seems unimportant. If all prices doubled overnight and wages followed suit, then you could afford exactly as much as before. But there are some less obvious problems with inflation. For example, inflation affects the distribution of income and wealth. It is unlikely that everyone s wages would increase at the same rate. Many people have long-term contracts specifying their wage in nominal terms, for example. Also, nominal assets like cash decrease in value when there is significant inflation. If you hold much of your wealth in cash, then inflation causes a significant decrease in real wealth for you. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

57 Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Problems with Anticipated Even if inflation is anticipated, it still causes problems. People and firms have increased real costs of holding cash. Firms have menu costs: the cost to firms of changing prices. Frequently changing prices are inconvenient for firms (and consumers too) to deal with. Investors are taxed on nominal returns, rather than real returns; so this can increase the tax due. Some taxes are not adjusted to account for inflation, such as the capital gains tax. Example: 1 January: you buy $10,000 worth of Apple stock 31 December: you sell the stock for $11,000, so your nominal capital gain is $1,000 (10%). Suppose π = 10% during the year. Your real capital gain is $0. But the government requires you to pay taxes on your $1,000 nominal gain! Shoeleather costs General inconvenience makes it harder to compare nominal values from different time periods. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

58 Measuring Problems with Unanticipated Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation When people cannot predict the rate of inflation, they find it hard to make good borrowing and lending decisions. For example, in 1980 banks were charging 18% or more on home loans because the rate of inflation was very high. People who bought homes were locked into high rates even when inflation subsided. On the other hand, if banks lend money at a low rate and then high inflation takes place, the real interest rate they receive may be zero or negative; thus the risk of inflation makes banks wary of lending. Increased uncertainty Unpredictable inflation makes borrowing and lending risky. Makes risk-averse people worse off. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

59 Measuring One Benefit of Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Nominal wages (W ) are rarely reduced. ( ) W allows the real wages to be reduced without nominal wage cuts. P Therefore, moderate inflation improves the functioning of labor markets. Labor markets will be discussed in the section The Supply Side Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

60 Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation What s So Bad about Falling Prices? Deflation is much more dangerous for an economy than inflation. Why? Suppose you are considering buying a car. You know the car will be cheaper next year, so you delay purchasing. But if everyone does the same, then many purchases are postponed, firms stop producing, people become unemployed, etc. This can create a dangerous downward-spiral, delaying economic recovery. Economists believe this occurred after the Great Depression of the 1930s, and also in Japan in the 1990s. There were concerns that significant periods of deflation might have followed the recession of but fortunately that did not occur. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

61 Measuring Hyperinflation Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation At its worst, inflation becomes hyperinflation an inflation rate that is so rapid that workers are paid multiple times a day because money loses its value so quickly. Common definition: π 50% per month All the costs of moderate inflation described above become HUGE under hyperinflation. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

62 Gross Domestic Measuring Adjusting for using Price Indexes Nominal Interest Rates versus Real Interest Rates The Costs of Hyperinflation Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

63 Measuring Measuring Types of The Problem of There are more than 300 million people in the United States, and monitoring and reporting on their activities regularly would be very difficult and costly. Instead, the U.S. Department of Labor reports estimates of employment, unemployment, and other statistics related to the labor force each month. Labor force: The sum of employed and unemployed workers in the economy. Of these statistics, the most watched is known as the unemployment rate: the percentage of the labor force that is unemployed. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

64 The Household Survey Measuring Types of The Problem of Each month, the U.S. Bureau of the Census conducts the Current Population Survey (a.k.a. the household survey). 60,000 households selected to be representative Household members of working age (16+ years old) Asked about employment during reference week Also asked about recent job-search activities People are then classified as: Employed: Worked 1+ hours in reference week (or were temporarily away from their jobs). Unemployed: Someone who is not currently at work but who is available for work and who has actively looked for work during the previous month Not in the labor force, if neither of the above apply Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

65 Civilian Working-Age Population (August 2013) Measuring Types of The Problem of Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

66 Rate Measuring Types of The Problem of Based on the CPS estimates, we calculate several important macroeconomic indicators. The most-watched is the unemployment rate: Number of unemployed 100 = rate Labor force 11.3 million million = 7.3% This most-common measure of unemployment is known formally as BLS series U-3. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

67 Measuring Types of The Problem of Labor Force Participation and Employment-Population Also important are the labor force participation rate (the percentage of the working-age population in the labor force)... Labor force = Labor force participation rate Working-age population million million = 63.2%... and the employment-population ratio (the percentage of the working-age population that is employed): Employment = Employment-population ratio Working-age population million million = 58.6% Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

68 Measuring Types of The Problem of Problems with Measuring the Rate The unemployment rate measured by the BLS is not a perfect measure of joblessness. Why? Discouraged workers: People who are available for work, but have not looked for a job during the previous four weeks because they believe no jobs are available for them. It may understate unemployment: Distinguishing between people who are unemployed and not in the labor force requires judgment (should we exclude discouraged workers?) Only measures employment, not intensity of employment (full-time vs. part-time; some people are underemployed) It may overstate unemployment: People might claim falsely to be actively looking for work May claim not to be working to evade taxes or keep criminal activity unnoticed Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85

69 Measuring Types of The Problem of Alternative Measures of : U-6 Some people suggest that we should include discouraged workers and underemployed workers in the unemployment statistics, to create a broader measure of unemployment. The BLS measures this, calling it BLS series U-6. Dennis C. Plott (UIC) Foundations: Macroeconomic Fundamentals ECON 121 Summer / 85