 Real GDP controls for inflation

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Real vs. Nominal GDP GDP is the value of all final goods and services produced. Nominal GDP measures these values using current prices. Real GDP measure these values using the prices of a base year.

Real GDP controls for inflation
Changes in nominal GDP can be due to: changes in prices changes in quantities of output produced Changes in real GDP can only be due to changes in quantities, because real GDP is constructed using constant base-year prices. Suppose from 2002 to 2003, nominal GDP rises by 10%. Some of this growth could be due to price increases, because an increase in the price of output causes an increase in the value of output, even if the real quantity remains the same. Hence, to control for inflation, we use real GDP. Remember, real GDP is the value of output using constant base-year prices. If real GDP grows by 6% from 2002 to 2003, we can be sure that all of this growth is due to an increase in the economy’s actual production of goods and services, because the same prices are used to construct real GDP in 2002 and 2003.

U.S. Real & Nominal GDP, Notice that the yellow line is steeper than the red line. That’s because prices generally rise over time. So, nominal GDP grows at a faster rate than real GDP. If you’re anal like me, you might ask students what is the significance of the two lines crossing in 1996. Answer: is the base year for this real GDP data, so RGDP = NGDP in 1996 only. Before 1996, RGDP > NGDP, while after 1996, RGDP < NGDP. This is intuitive if you think about it for a minute. Take When the economy’s output of 1970 is measured in the (then) current prices, GDP is about \$1 trillion. Between 1970 and 1996, most prices have risen. Hence, if you value the country’s 1970 using 1996 prices (to get real GDP), you get a bigger value than if you just measure 1970’s output in 1970 prices (nominal GDP).

U.S. Gross Domestic Product in billions of chained 1996 dollars
long-run upward trend… This graph shows data on U.S. Gross Domestic Product. For now, it suffices for students to know that GDP is a measure of the economy’s total output and total income, and that the data in this chart have been adjusted to take out the effects of inflation. (In Chapter 2, students will learn the exact definition of GDP, how it’s measured, and how it’s corrected for inflation). There are two main points students should get from this graph. First, over the long run, there’s a clear upward trend. One of the most important issues in macroeconomics is understanding this long run growth: what determines how fast a country grows over the long run, how do government policies affect the growth rate, and how could we achieve faster growth? This topic is critical, because it’s very tightly linked to our standard of living. (continued next slide….)

How the BLS constructs the CPI
Survey consumers to determine composition of the typical consumer’s “basket” of goods. Every month, collect data on prices of all items in the basket; compute cost of basket CPI in any month equals

Exercise: Compute the CPI
The basket contains 20 pizzas and 10 compact discs. prices: pizza CDs 2000 \$10 \$15 2001 \$11 \$15 2002 \$12 \$16 2003 \$13 \$15 For each year, compute the cost of the basket the CPI (use 2000 as the base year) the inflation rate from the preceding year From 2002 to 2003, it’s not obvious that the inflation rate will be positive (that the basket’s cost will increase): the price of pizza rises by \$1, the price of CDs falls by \$1. However, since the basket contains twice as many pizzas as CDs, a given change in the price of pizza will have a bigger impact on the basket’s cost (and CPI) than the same sized price change in CDs.

answers: cost of inflation basket CPI rate 2000 \$350 100.0 n.a.
% % %

The composition of the CPI’s “basket”
Each number is the percent of the “typical” household’s total expenditure. source: Bureau of Labor Statistics, Ask students for examples of how the breakdown of their own expenditure differs from that of the typical household shown here. Then, ask students how the typical elderly person’s expenditure might differ from that shown here. (This is relevant because the CPI is used to give Social Security COLAs to the elderly; however, the elderly spend a much larger fraction of their income on medical care, a category in which prices grow much faster than the CPI.) The website listed above also gives a very fine disaggregation of each category, which enables students to compare their own spending on compact discs, beer, or cell phones to that of the “typical” household.

GDP Deflator The inflation rate is the percentage increase in the overall level of prices. One measure of the price level is the GDP Deflator, defined as After revealing the first bullet point, mention that there are several different measures of the overall price level. Your students are probably familiar with one of them---the Consumer Price Index, which will be covered shortly. For now, though, we learn about a different one <reveal next bullet point>, the GDP deflator. The GDP deflator is so named because it is used to “deflate” (remove the effects of inflation from) GDP and other economic variables.

Two measures of inflation
Percentage change 16 CPI 14 12 10 GDP deflator 8 Be sure to point out that the data are the percentage changes, not the levels, of the CPI and the GDP deflator. In 1980, the CPI increased much faster than the GDP deflator. Ask students if they can offer a possible explanation. In 1955, the CPI showed slightly negative inflation, while the GDP deflator showed positive inflation. Ask students for possible explanations. (For possible answers, just refer to previous slide.) 6 4 2 - 2 1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 Year

Okun’s Law Employed workers help produce GDP, while unemployed workers do not. So one would expect a negative relationship between unemployment and real GDP. This relationship is clear in the data…

Okun’s Law Okun’s Law states that a one-percent decrease in unemployment is associated with two percentage points of additional growth in real GDP Percentage change in real GDP 10 -3 -2 -1 1 2 4 3 8 6 1951 1984 2000 1999 1993 1975 1982 Change in unemployment rate

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