Wednesday, November 7 Lecture: Gross Domestic Product Continued, Price Indices, and Inflation

Transcription

1 Amherst College Department of Economics Economics 111 Section 3 Fall 2012 Wednesday, November 7 Lecture: Gross Domestic Product Continued, Price Indices, and Inflation Nominal GDP Nominal GDP for 2011 = Sum of the market values of all final goods and services produced in the United States during 2011 = P2011 Auto + P2011 Beer = $15,100 U.S. Household U.S. Firm U.S. Government U. S. Net = Purchases of + Purchases of + Purchases of + Exports of Final G&S (C) Final G&S (I) Final G&S (G) Final G&S (NX) = 10, , , = 15,100 Checking the Calculations Suppose that all the firms in the U.S. were combined into a huge conglomerate, call it USA, Inc. We shall now calculate the profits of this hypothetical conglomerate. Total Revenue = Nominal GDP = $15,100 Total Cost = Employee Compensation + Rents + Interest + Depreciation + Business Taxes Employee Compensation 8,290 Rents 400 Interest 710 Depreciation 1,950 Business Taxes 1,160 Total 12,510 Calculated Profit = Total Revenue Total Cost = 15,100 12,510 = 2,590 Measured Profit Corporate Profits 1,510 Proprietor Profits 1,110 Total 2,620 What is the difference between calculated and measured profits?

2 2 Disposable Income: Income Households Have Available To Spend 2 Disposable income measures the amount of income that households have available to spend. Disposable income equals the income households earn less the taxes households pay to the government plus transfers households receive from the government. Disposable income and GDP are related. To understand how we begin with what we mean by profits. Profits = Total Revenue Total Cost Recall the definition of GDP Nominal GDP for 2011 = Sum of the market values of all final goods and services produced in the United States during 2011 = P2011 Auto + P2011 Beer = $15,100 GDP equals the total revenue of automobile firms plus the total revenue of beer firms, etc.; that is, GDP equals the sum of the total revenues of all firms. We can divide the costs of all firms into five large categories: Employee Compensation (wages, salaries, benefits, etc.) Rents Interest Depreciation (plants, factories, equipment, etc. that wears out) Business Taxes Substituting Profits = Total Revenue Total Cost Profits = GDP (Empl Comp + Rents + Interest + Dep + Bus Taxes) Empl Comp + Rents + Interest + Profits = GDP Dep Bus Taxes Employee compensation, rents, interest, and profits are all sources of household income. Household Income = GDP Dep Bus Taxes Household Income Pers Taxes + Trans = GDP Dep Bus Taxes PersTaxes + Trans Disposable Income = GDP Dep Taxes + Trans Disposable income equals the income households earn less the taxes households pay to the government plus transfers households receive from the government. In general, Disposable Income = GDP Depreciation = GDP Dep (Taxes Trans) = GDP Dep Net Taxes = 15,100 1,950 1,540 = 11,610 Net Taxes 2 Some liberties have been taken to avoid the technical accounting details.

3 3 Two Roles of the Government in the Macro Economy Purchasing of Final Goods and Services: Government Purchases for Final Goods and Services Affecting the Disposable Income of Households o By collecting taxes o By distributing transfer payments Savings versus Investment It is important to make a distinction between savings and investment. Savings equals the income households have available to spend less the income that they actually spends. Savings equals disposable income less consumption Savings = disposable Income Consumption Households make savings decisions. On the other hand, investment refers to new plants, new factories, new equipment, etc. that our economy produces. Firms make investment decisions. Investment represents physical items whereas consumption is the lack of consumption. The Role of Federal, State, and Local Government Before moving on, let us reconsider the government s role in the economy. First, note that state and local governments purchase more final goods and services than does the federal government. U. S. Government Purchases of Final Goods and Services 3,030 Federal 1,230 National defense 820 Nondefense 410 State and local 1,800 Also, note that most of the federal government s purchases go for defense; that is, most of the federal government s purchases are spent on military personel, guns, munitions, aircraft, ships, etc. But wait a second. According to the table the federal government is spending $1,230 billion, yet isn t the federal budget well over two trillion dollars? What is going on here? All federal government s outlays can be divided into two broad categories: government purchases for final goods and services; transfer payments. The federal government not only purchases final goods and services, it also administers transfer programs. These programs transfer income from one group of Americans to another. The largest transfer program is Social Security which transfers income from those who are working primarily to those who are retired. The federal budget figure that is cited on the evening news includes not only the purchase of goods and services, but also transfer programs. The Federal deficit equals all federal expenditures less Federal receipts. Total Federal Total Federal Federal Deficit = Government Government Expenditures Receipts Federal Federal Purchase of + Transfer of Final G&S Payments We shall return to this later in the semester.

4 4 Real GDP versus Nominal GDP Now, let us reflect a little. Why did we introduce the notion of nominal GDP in the first place? We wanted a way to measure how many goods the economy as a whole was producing. Does a rising nominal GDP always indicate a robust, healthy economy that is producing more goods? To address this question, let us look at the nominal GDP equation more carefully: Nominal GDP for 2011 = Sum of the market values of all final goods and services produced in the United States during 2011 = P2011 Auto + P2011 Beer = $15,100 Nominal GDP can increase for two reasons: the Q s can rise the P s can rise If nominal GDP rises because the Q s increase, then the rising nominal GDP would indeed indicate that the economy was producing more goods. But GDP could rise as a consequence of rising prices, P s, with the Q s remaining the same or even falling. In this latter case, a rising GDP would not indicate a robust, growing economy. Since both an increase in the Q s and an increase in the P s can cause a rise in nominal GDP, nominal GDP itself cannot tell us what is happening to the Q s, the production of goods. For this reason, we shall now introduce a new concept, real GDP, which can only rise when the Q s increase. Consequently, when real GDP increase we can conclude confidently that our economy is producing more goods. Real GDP is what nominal GDP would have equaled if prices had not changed from their base year values. Currently, the base year used by the Department of Commerce is 2005: Real GDP for 2011 = Sum of the market values of all final goods and services produced in the United States during 2011 evaluated at base year (2005) prices = P2005 Auto + P2005 Beer = $13,320 Is this just an academic exercise or are there cases in which relying on nominal GDP as a measure of how many goods the economy produced would have led to incorrect conclusions? The answer to this question is yes. The years 1990 and 1991 provide one example: Year Nominal GDP Real GDP ,030 13, ,290 13,160 In 2008 nominal GDP rose despite the fact that real GDP fell; that is, nominal GDP rose while the production of goods in the economy actually fell. Let us look at real GDP and its components over time:

5 Of course some of this growth is attributable to population growth; accordingly, let us consider the per capita figures: 5

6 6 Measures of inflation: Changes in prices When prices on average rise, our economy experiences inflation. How do we measure prices on average? A price index does this for us; a price index describes the average level of prices in the economy. The two most commonly used price indices are: GDP price deflator Consumer price index (CPI) The GDP price deflator accounts for the price of all final goods and services in the economy; it accounts not only for the prices of goods that households purchase, but also for the prices of goods that firms and governments purchase. The consumer price index focuses only on the prices of goods purchased by households. GDP deflator The GDP price deflator equals the ratio of nominal and real GDP multiplied by 100: Nominal GDP for 2011 GDP deflator for 2011 = Real GDP for P2011 Auto Q 2011 Auto + P2011 Beer = P2005 Auto + P2005 Beer Q Beer What would the GDP deflator for 2011 equal if prices had not changed between the base year, 2005, and 2011? If prices had not changed, the numerator and denominator of the fraction would be the same; the GDP price deflator would equal 100. What would the GDP price deflator for 2011 equal if prices had doubled between the base year, 2005, and 2011? If prices had doubled, the numerator of the fraction would be twice as large as the denominator; the GDP price deflator would equal 200. What would the GDP price deflator for 2011 equal if prices had tripled between the base year, 2005, and 2011? If prices had tripled, the numerator of the fraction would be three times as large as the denominator; the GDP price deflator would equal 300. GDP Price Deflator If prices had remained the same 100 If prices had doubled 200 If prices had tripled 300 The GDP price deflator tells us what has happened to prices since the base year. What actually has happened to the GDP price deflator? = P2011 Auto Q 2011 Auto + P2011 Beer P2005 Auto + P2005 Beer 15,100 = 13, = Between the base year, 2005, and 2011 prices increased by about 13 percent.

7 7 Consumer Price Index (CPI) As mentioned before, the consumer price index focuses only on the goods households consume. The Bureau of Labor Statistics, an agency of the U.S. Department of Labor, calculates the consumer price index monthly. Three steps are required to do so: First, the Bureau of Labor Statistics decides upon the market basket of goods that is purchased by the typical American household. As you might expect, this market basket contains a wide variety of goods: x lbs of chicken y lbs of tuna z cans of beer n cans of soda. Second, the Bureau of labor statistics calculates how much this market basket would have cost in the base year and how much it costs now. 3 Last, it calculates the ratio of the costs and by convention multiplies the ratio by 100. The result is the CPI: Cost of the Market Basket in September 2012 CPI for September 2012 = Cost of the Market Basket in the Base Year x 100 By comparing the CPI from month to month or year to year, we can see how the cost of the market basket of goods has changed: Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec For reasons that are not worth discussing, the Bureau of Labor Statistics does not use a single year as its base year; instead, the base year for the CPI extends over three years:

8 8 CPI and the rate of inflation Between February 2011 and February 2012, the CPI rose from to 227.7, a = 2.9 percent increases; the cost of the typical market basket of goods rose by 2.9 percent. Since the goods in the market basket did not change, the prices of those goods rose by an average of 2.9 percent; that is, the rate of inflation was 2.9 percent between February 2011 and February The rate of inflation reflects how prices of the goods in the typical market basket have changed on average, expressed in percentage terms. Inflation and Purchasing Power Increase in Change in Purchasing Power: Nominal Per Capita Increase in Change in Real Per Capita Disposable Income (%) CPI (%) Disposable Income (%) CPI and Standard of Living Many labor contracts have explicit costs of living adjustments that are based on the CPI; workers receive automatic wage increases the size of which is determined by how much the CPI increases. These contracts are designed to protect the worker s standard of living in an inflationary period. Social Security benefits are also indexed to the CPI. Every year, social security benefits rise by an amount equal to the previous year s CPI increase. For example, if the CPI rises by 2 percent, Social Security benefits will rise by 2 percent. This is designed to keep protect retirees from seeing the purchasing power of their benefits decline as a consequence of inflation. Between June 2009 and June 2010 the CPI rose by 1.0 percent. If Smith household s income also rose by 1 percent and the Smiths were purchasing the typical market basket of goods, then the Smiths would be the spending the same portion of its income on the typical market basket of goods. This of course assumes that the Smiths continue to purchase the typical market basket of goods. More generally, assuming that a household consumes the typical market basket of goods we can conclude that if Income increase = CPI increase Standard of living the same Income increase > CPI increase Standard of living up Income increase < CPI increase Standard of living down

9 9 There is reason to believe, however, that changes in the CPI overstate the effects of inflation for two reasons: substitution; quality changes. While most economists agree that an overstatement exists, there is disagreement about the magnitude of the overstatement. Some economists believe that it is large and should be accounted for; others believe that it is small and not worth worrying about. Let us briefly consider two sources of the overstatement. Effect of substitution Suppose that Ms. Jones cannot tell the difference between Coke and Pepsi. At the present time, the prices of the two soft drinks are the same; therefore, Ms. Jones does not prefer one brand to the other; so, she sometimes buys Coke and sometimes Pepsi. What would happen if the price of Pepsi rose? The CPI would rise. Would Ms. Jones be worse off? No. You would now only buy Coke because it is cheaper. Since she cannot even tell the difference, she would be no worse off because the price of Coke has not changed. The CPI has risen, but Ms. Jones has not been hurt at all because she will substitute Coke for Pepsi. Now, let us return to the Smith household. Suppose that in June 2009, the Smith household was using all its income to purchase the typical market basket of goods; during the next year its income rose by 1.0 percent, an amount just equal to the increase in the CPI. Consequently, in January 2004, the Smiths can just afford to continue purchasing the typical market basket of goods. If it did this, it would remain just as well off. But, will it do so? To answer this question, consider what has happened since then to the price of ground beef and chicken. Ground Beef ($/lb) Whole Chickens ($/lb) June June Percent change 3.1% 3.1% While the price of ground beef rose, the price of whole chickens fell. The Smith household will react to this. It could alter its consumption pattern by purchasing less ground beef and more chicken. If it had not altered its consumption pattern it would have remained just as well off by continuing to consume the typical market basket of goods; by substituting chicken for ground beef, however, it would become better off. So, what is the moral here? The CPI tells us what happens to the price of goods on average. The price of some goods goes up by more the average, while the price of others by less. Now, consider the typical household, that is, the household that consumes the typical market basket of goods. When this household s income rises by an amount equal to the CPI, it can improve its standard of living by altering its consumption patterns. It would buy more of the good that became relatively cheaper and less of the good that became relatively more expensive. Consequently, the CPI overstates the effect on a household s standard of living.

10 10 Effect of quality improvements Personal computers provide a good illustration of this phenomenon. During the last twenty years, technological advances have made a personal computer a much better product. Clock speeds have risen from less than 1 megahertz to 600 or so. The original IBM PC had no hard drive and 512 kilobytes of memory. The first IBM personal computer with a hard drive, the IBM XT, only had a 10 megabytes storage capacity. The CPI does not capture these quality improvements sufficiently. Social Security Benefits and the CPI: What if the household does not consume the typical market basket of goods? As mentioned above, Social Security benefits are typically adjusted for the change in the CPI each year. Obviously, substitution and quality improvements cause the CPI to overstate the effect of inflation somewhat. On the other hand, for Social Security recipients, another factor provides a countervailing influence. Most people who receive Social Security benefits are retired, over 65 years of age. Older individuals tend to consume more medical services. The price of medical services has been rising significantly faster than prices in general. Between June 2009 and June 2010, while prices on average rose by 1.0 percent, medical care prices rose by 3.5 percent. Consequently, for Social Security it is not clear if the annual CPI adjustment overstates or understates the effect that inflation has on those retired individuals receiving benefits. Real and Nominal Interest Rates The nominal interest rate on a savings account is the interest rate that is advertised by a bank. The real interest rate reflects purchasing power and therefore takes inflation into account: Real Nominal Interest = Interest Inflation Rate Rate Rate To understand why the real interest rate, nominal interest rate, and the inflation rate are related in this way, suppose that a bank offers a 3 percent nominal interest rate and the inflation rate is 2 percent. This means that if you save $100 after one year, you would earn $3 of interest: 3% 100 = 3 Over the course of the year you have earned $3 of interest on the $100 of principle. On the other hand, prices have risen by 2 percent during the year; this means that the purchasing power of the $100 of principle has eroded by $2. Consequently, your purchasing power has increased by $1, a 1 percent increase: Nominal Interest Inflation Real Interest Rate = 3% Rate = 2% Rate = 1% Save $100 $3 of $2 Erosion of $1 Net Increase for a year Interest Purchasing Power in Purchasing Power

11 Since 2002 real interest rates have been low. In fact, they have often been negative. When they are negative, the saver loses purchasing power. 11