Learning Module Design Tool - WVU College of Business and

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Business & Economics - Learning Module Design Tool
Learning Module Construction Tool
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Module Title:
Put the title of your module in this box(6 words or less).
Module 2: Measuring National Income, Prices, and Unemployment
Module Reading Assignment(s):
Required Reading:
Mankiw, Brief Principles of Macroeconomics, Chapter 5
Mankiw, Brief Principles of Macroeconomics, Chapter 6
Mankiw, Brief Principles of Macroeconomics, Chapter 10, first section, “Identifying
Unemployment”
Module Overview:
Put your introductory or overview paragraph for the module in this box(No more than
half a page).
Macroeconomics concerns the performance of the economy as a whole. The key
statistics that tell us about the economy’s performance include Gross Domestic
Product (GDP), the Consumer Price Index (CPI), and the Unemployment Rate. GDP
measures overall production and income, CPI measures consumer inflation and the
value of the dollar to consumers, and the unemployment rate measures job
opportunities and the efficiency with which the economy is using its labor resources.
In this module, we explore how those statistics are calculated, what they actually
measure, and their strengths and weaknesses as measures of the health and wellbeing of the economy. Along the way we’ll look at some related statistics, including
the GDP deflator, core inflation, the labor force participation rate, and alternative
measures of unemployment, that shed further light on the performance of the
economy.
We will also make the important distinction between the nominal variables that we see
every day, which are measured in current dollar prices, and the real variables of
primary interest that lie behind those nominal values. We will see that real values
reflect flows of physical goods and services, whereas nominal values reflect mere
flows of money. You will learn how Real GDP is calculated and why it is a better
This help sheet was developed by West Virginia University iDesign.
measure of economic welfare than Nominal GDP. You will also learn how price
indices such as the CPI may be used to convert nominal consumer income and
nominal prices to real values.
Objectives:
Put your learning objectives into this box. Objectives should be measurable and
achievable, and simply stated. Use verbs such as describe, discuss, analyze,
present, create, construct, and research.
By the end of this module, students will be able to:
I.
Define Gross Domestic Product (GDP) and its four major components,
and explain how they are measured.
2. Distinguish between real and nominal GDP and calculate both real
GDP and the GDP deflator from data on production and prices.
3. Explain the significance of both nominal and real GDP and explain the
strengths and weaknesses of GDP as a measure of economic wellbeing.
4. Define the Consumer Price Index (CPI), explain how it is measured,
and use it to calculate the inflation rate.
5. Use the CPI and the inflation rate to convert nominal values (including
nominal interest rates) to real values, and explain the value and
significance of these conversions.
6. Compare and contrast the methods and uses of various alternative
measures of price levels, including the GDP Deflator and Core CPI.
7. Calculate the unemployment rate and the labor force participation rate
using data on employment, job seeking behavior, and population.
8. Explain the significance of the unemployment rate and labor force
participation rate, and their strengths and weaknesses as measures of
current conditions in the labor market and economic welfare.
9. Calculate the amount of unemployment caused by the business cycle
(“Cyclical Unemployment”), and explain how it relates to the
economy’s Natural Rate of Unemployment.
Suggested Content for Online Presentation:
Mankiw Chapter 5: Measuring a Nation’s Income
A. Income and Expenditure in the Economy as a Whole
“Expenditure” means the same thing as “spending.”
For the economy as a whole, income = expenditure because each transaction
has a buyer (expenditure) and a seller (income).
The equivalence of spending and income is just the Circular Flow Model showing
up again:
Spending (expenditure) in the product markets flows into income (wages, rents,
interest and dividends) in the resource markets as firms pay for their resources in
order to produce the products households buy.
GDP attempts to measure the flow of real goods and services (and therefore the
economic well-being of society) by measuring the flow of dollars spent on those
real goods and services.
GDP can be measured anywhere on the circular flow. It is both the flow of
spending through the product markets, and the flow of income through the
resource markets, so whether you measure it as income or expenditure you will
get the same number (within a reasonable margin of error).
Measurement of Gross Domestic Product
GDP is computed by the Bureau of Economic Analysis (BEA),
http://www.bea.gov/ every three months (quarter-year, or simply quarter).
GDP measures the FLOW of income = expenditure = production.
Definition: GDP is the market value of all final goods and services
produced within a country in a given period of time.
Let’s break down this definition into its parts:
1. “MARKET VALUE” is measured in dollars rather than tons or other physical
units so we can compare apples and oranges and medical services and
other disparate goods and services. Market value is a good measure
because it reflects the value put on the goods and services by their users.
2. “ALL” includes all goods and services traded on legal markets.
EXCLUDED from this measurement of “all goods and services” are:
Non-market goods and services (garden vegetables, bartered goods,
services within family), so if you quit changing your own oil and start taking
your car to Grease Monkey you’ll increase GDP without really increasing
economic well-being.
Illegal goods and services. So making marijuana legal will increase GDP
without directly increasing economic wellbeing.
3. “FINAL GOODS AND SERVICES” means goods and services that are sold to final
consumers.
So, if a bag of flour is sold to your mom for her home baking, that sale counts
as GDP. If that same bag of flour had been sold to a commercial bakery to
be made into bread, it would not count directly into GDP. (Its cost appears
indirectly in GDP as part of the price charged by the bakery for the finished
loaf of bread, which does count).
This rule is in place to avoid “Double Counting,” in other words to avoid
counting the value of the flour twice.
An exception: Goods held in INVENTORY (i.e., produced but not sold) by their
manufacturers at the end of the year count in GDP for the year they are
produced, as part of inventory investment.
So, if the flour mill produces a bag of flour for the bakery in 2012 but does
not sell it to the bakery until 2013, it counts as inventory investment in 2012
GDP. When it is sold in 2013, it is subtracted from inventory investment for
2013, though the bread baked and sold in 2013 does count in 2013 GDP.
Another exception: Any EXPORTED good or service counts in GDP when it
crosses the border. So if flour produced in an American mill is sold to a
Canadian baker, it counts in US GDP in the year it’s exported.
4. PRODUCED means currently produced (not resold items). So the sale of a
used car does not count in current GDP, though the services of the salesman
do count.
5.
means that GDP is defined geographically, whether its
production is by citizens or non-citizens. So if a Canadian works in the US
flour mill, his production counts as part of US GDP.
WITHIN A COUNTRY
6.
IN A GIVEN PERIOD OF TIME,
is usually calculated quarterly or yearly.
GDP is a rate of flow of goods and services per time period. When
calculating GDP for a given quarter we want to count only (and all)
production that occurred within the current quarter. So a bicycle produced in
November 2013 is counted in 4th quarter 2013 production, regardless of
when it is sold. That’s why we count inventory changes in current GDP, as
explained above.
A couple of wrinkles:
Quarterly data are usually stated in annual terms. When the BEA announces
quarterly GDP, it takes the GDP for that quarter and reports the amount that
would be produced in a year if the whole year were like that quarter.
(Roughly, it multiplies the quarterly amount by four.)
Quarterly data are usually seasonally adjusted. That is, when reporting
quarterly figures at an annual rate the BEA adjusts its figures for the fact that
there’s usually more production in some quarters than in others (due to
Christmas, for example). So, computing the annual rate is not really as
simple as multiplying the actual amounts by four.
Restated, we say that the quarterly figures are reported “SAAR” (Seasonally
Adjusted, Annual Rate).
This graph, from the Federal Reserve Economic Data (FRED II) website
http://research.stlouisfed.org/fred2/graph/?id=GDP, shows quarterly nominal
GDP calculated SAAR from 2003 through 2013. You can easily see the
depressing results of the 2008 financial collapse. The gray bar indicates the
recession. I encourage you to go to the FRED site
http://research.stlouisfed.org/fred2/categories
for all your macro data needs!
Components of GDP: Y = C + I + G + NX
It’s useful to break down the total expenditures (call it “Y”) in the economy into
four components: Consumption (C), Investment (I), government spending on
goods and services (G), and net exports (NX = Exports minus imports). I will
define each of these components in turn.
We can write GDP (which is total expenditures, or Y) as the sum of these
four components:
Y = C + I + G + NX
Remember this equation! It will come up over and over again in this class!
Here is an explanation of the four components of spending:
Consumption (C) is spending by households on goods and services.
Consumption includes
1) Goods include both durable and non-durable goods.
Durable goods, such as appliances and cars, last a long time.
Non-durable goods, such as food and fuel, are consumed immediately.
2) Services include categories such as education and doctors’ services.
Consumption does not include purchases of new houses. New houses are
classified under Investment.
Consumption is typically about 70% of GDP, and this proportion is
generally pretty stable from year to year.
Investment (I) is short for “Gross Private Domestic Investment. It includes:
1) Private (that is, non-governmental) spending by firms on capital equipment
and structures. That is, if a firm builds a new factory, buys new computers for
the office, builds a new store, buys a new truck or buys new machinery, it’s
Investment.
2) Investment also includes inventory changes, which is the accumulation by
firms of goods they haven’t sold yet. As stated above, this makes sure that
goods produced in a given year are counted in GDP for that year, regardless
of when they are actually sold.
Note that if a car valued at $30,000 was produced last year, and is sold to a
consumer out of inventory this year, it will increase last year’s investment (I)
by 30,000, and will increase this year’s consumption (C) by $30,000, but will
decrease this year’s investment (I) by $30,000 and therefore have no net
impact on this year’s GDP.
3) Investment also includes purchases of new housing (by households).
Investment is typically about 15% of GDP, and this proportion varies
widely from year to year. Changes in investment often kick off
recessions and booms.
Government Purchases (G) include spending on goods and services by all
levels of government.
G includes spending by all levels of government, not just the Federal
government. Therefore, when your county government spends money to fix
potholes, it’s part of G just as much as the cost of a new missile purchased
by the federal government.
G includes includes salaries of government employees.
G is not exactly the same as what we usually think of as government
spending because it does not include TRANSFER PAYMENTS. Transfer
payments are payments by the government that are not purchases of goods
and services, such as Social Security payments, unemployment benefits,
and welfare payments. (Such payments are used by their recipients to buy
goods and services, at which point the dollars spent are counted as
consumption (C).) Transfers are a large and growing portion of the
government’s total spending, but they are not part of G.
G is typically about 20% of GDP.
Net Exports (NX) equals exports minus Imports.
1) Exports are goods and services produced within the United States that are
purchased in foreign countries. Increasing exports adds to GDP.
2) Imports are goods and services produced in another country that are
purchased by people and firms in the U.S. Imports subtract from GDP.
Note that if a U.S. consumer buys an imported good, that purchase will increase
U.S. consumption (C), but lower U.S. net exports (NX) by an equal amount and
therefore will have no net impact on U.S. GDP.
Net Exports is typically about -5% (that is, negative five percent) of U.S.
GDP. It is negative because U.S. imports typically exceed U.S. exports.
II. Real vs Nominal GDP
GDP attempts to measure economic well-being using dollar value of goods and
services. One big problem with using dollar GDP as a measure of well-being is
that the value of a dollar varies from year to year because of inflation. Usually,
the value of a dollar falls each year, so it’s as if our measuring stick of value is
shrinking from one year to the next.
To compare GDP from one year to the next, therefore, we need to somehow
“standardize” our measuring stick. That is, we need to use “standard” dollars.
“Standard dollars” implies standard prices. In other words, to compare production
from one year to the next we need to use a standard set of dollar prices to value
that production. Generally, we use the prices that prevailed in a base year for our
standard.
Another way of putting this problem is that we want to convert our measure of
Nominal GDP to a measure of Real GDP. “Nominal GDP” refers to production
measured using prices that were current during the year of production. “Real
GDP” refers to production measured using prices from a standard “base” year.
To summarize succinctly:
Nominal GDP is measured using current dollars.
Real GDP is measured using “constant dollars.”
Calculating Real GDP:
I can restate what I said above in the form of two equations:
Nominal GDP = Value of GDP in Current-Year Prices
Real GDP = Value of GDP in Base-Year Prices
In the following, I suggest that you test your understanding by trying to fill in the
empty columns before I show you what is in them.
Here’s a table that illustrates how you calculate nominal and real GDP for a very
simple economy with only one product, coffee. Can you fill in at least some of the
blanks? Try it!
Year
Price of
Coffee
Quantity of
Coffee
Produced
2001
$ .50
100
2002 (base)
$1.50
200
2003
$ 2.50
150
Nominal
GDP
Real
GDP
GDP
Deflator
OK, now I will show you how to fill in the blanks. Nominal GDP is easy to
calculate: Simply multiply the price of coffee in each year times the quantity of
coffee produced in that year.
Year
Price of
Coffee
Quantity of
Coffee
Produced
Nominal
GDP
2011
$ .50
100
$50
2012 (base)
$1.50
200
$300
2013
$ 2.50
150
$375
Real
GDP
GDP
Deflator
For example, I calculated 2011 Nominal GDP by multiplying
P2011 x Q2011 = $.50 x 100 = $50, and I did the same thing for the other two years.
Notice that, because the price of coffee increased between 2012 and 2013,
nominal GDP increased even though the amount of coffee produced declined by
nearly 17%. See the problem with nominal GDP?
OK, let’s get a better dollar measure of output by using constant dollars to
calculate Real GDP. I am going to pick 2012 as the “base year” whose prices
we’ll use. This is completely arbitrary; I could have picked any year as the base,
but I do have to use the same price to calculate Real GDP for all years. To
calculate the Real GDP dollar amount for each year I will use the base year price
of $1.50, multiplied by the current year’s quantity of output:
Year
Price of
Coffee
Quantity of
Coffee
Produced
Nominal
GDP
Real
GDP
2011
$ .50
100
$50
$1.50
2012 (base)
$1.50
200
$300
$300
2013
$ 2.50
150
$375
$225
GDP
Deflator
For example, I calculated 2011 Real GDP by multiplying
P2012xQ2011 = $1.50 x 100 = $150 and I did the same thing for the other two
years. (So, Real GDP2013 = P2012 x Q2013.)
Notice that Real GDP rises and falls with output, so Real GDP in 2012 is twice
Real GDP for 2011 instead of six times higher, and it falls in 2013.
Notice also that Real GDP and Nominal GDP are the same for the base year.
Why is this true?
There’s one more column in the table: GDP Deflator. The GDP Deflator is what
we call a price index. It expresses that year’s price level relative to the base year.
Stated formally,
GDP Deflator =
Nominal GDP
Real GDP x 100
Let’s calculate the GDP Deflator using this formula:
Year
Price of
Coffee
Quantity of
Coffee
Produced
Nominal
GDP
Real
GDP
GDP
Deflator
2011
$ .50
100
$50
$1.50
33.3
2012 (base)
$1.50
200
$300
$300
100
2013
$ 2.50
150
$375
$225
166.7
Note that the GDP Deflator goes up and down with the price level. For example,
it triples from 2011 to 2012, as does the price of coffee.
Note also that the GDP Deflator is 100 in the base year (2012). That’s generally
true of price indexes: they all equal 100 in the base year.
Why is the GDP Deflator called a Deflator? Because when you divide it into the
Nominal GDP it will “deflate” the Nominal GDP to Real GDP. Rearranging the
last formula, we get:
Nominal GDP
Real GDP = GDP Deflator x100.
You could say that the deflator is the remedy for inflation, at least for purposes of
calculating Real GDP. As we’ll see later, all price indexes are useful in this way:
we can always deflate a nominal value to its real base-year value by dividing by
the appropriate price index.
If there’s only one product in the economy, this whole exercise is pretty trivial.
The BEA in our fictional one-product economy could make its job simpler if it just
measured Real GDP in pounds of coffee. The BEA of a more complex country
such as the U.S., however, does not have this option. It has to measure GDP in
dollars, for reasons already explained.
OK, so let’s do the same exercise as above, but this time for a country that
produces both sugar and coffee:
Price of
Coffee
Quantity
of Coffee
Produced
Price of
Sugar
Quantity
of Sugar
Produced
2011
$ .50
200
$1.00
10
2012 (base)
$1.50
400
$2.00
40
2013
$ 2.50
300
$3.00
20
Year
Nominal
GDP
Real
GDP
Can you fill in the three blank columns in the table? Just apply the same
principles we did for the one-product economy.
GDP
Deflator
To fill in the Nominal GDP, again just add up the value of all the production in the
economy using current year prices, the same way the checkout person does
when you bring a basket of groceries to the counter at Kroger’s.
For 2011, for example, Nominal GDP2011 = $.50 x 200 + $1.00 x 10 = $110.
Price of
Coffee
Quantity
of Coffee
Produced
Price of
Sugar
Quantity
of Sugar
Produced
2011
$ .50
200
$1.00
10
$110
2012 (base)
$1.50
400
$2.00
40
$680
2013
$ 2.50
300
$3.00
20
$810
Year
Nominal
GDP
Real
GDP
GDP
Deflator
To fill in the values for Real GDP, use the base year (2012) prices and currentyear quantities. For example, for 2013 Real GDP we use 2013 quantities:
Real GDP2013 = ($1.50 x 300) + ($2.00 x 20) = $490.
Doing the same thing for 2011 and 2012 gives you Real GDP for all years:
Price of
Coffee
Quantity
of Coffee
Produced
Price of
Sugar
Quantity
of Sugar
Produced
2011
$ .50
200
$1.00
10
$110
$320
2012 (base)
$1.50
400
$2.00
40
$680
$680
2013
$ 2.50
300
$3.00
20
$810
$490
Year
Nominal
GDP
Real
GDP
GDP
Deflator
And again, the GDP Deflator is just (Nominal/Real)x100. For example, for 2013
it’s GDP Deflator2013 = (810/490)x100 = 165.3. Doing the same calculation for
2012 and 2011 we get the deflators for all three.
Price of
Coffee
Quantity
of Coffee
Produced
Price of
Sugar
Quantity
of Sugar
Produced
2011
$ .50
200
$1.00
10
$110
$320
34.4
2012 (base)
$1.50
400
$2.00
40
$680
$680
100
2013
$ 2.50
300
$3.00
20
$810
$490
165.3
Year
Nominal
GDP
Real
GDP
GDP
Deflator
Note again that Real GDP does a much better job of tracking the changes in
output of real goods than Nominal GDP does.
III. GDP and Well-Being: A Pretty Good Measure
The purpose of GDP is to measure economic well-being. When averaged over
the population, it measures income per capita, which is a pretty good, but
imperfect measure.
Speaking at the University of Kansas during his presidential campaign in March
1968, Robert F. Kennedy said:
“Our gross national product ... counts air pollution and cigarette
advertising, and ambulances to clear our highways of carnage.
It counts special locks for our doors and the jails for those who
break them. It counts the destruction of our redwoods and the
loss of our natural wonder in chaotic sprawl. It counts napalm
and the cost of a nuclear warhead, and armored cars for police
who fight riots in our streets. . . .
Yet 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 wit nor
our courage; neither our wisdom nor our learning; neither our
compassion nor our devotion to our country; it measures
everything, in short, except that which makes life worthwhile.
And it tells us everything about America except why we are
proud that we are Americans."
This is true enough, as far as it goes. On the other hand, real GDP is well and
positively correlated through time and across countries with life expectancy,
literacy, low infant mortality, Olympic medals, environmental quality, and many
other measures of things that clearly do matter.
See, for example, this chart showing income per capita and life expectancy in
2012, from Gapminder: (http://www.gapminder.org/downloads/world-pdf/)
(By the way, you can create your own charts at http://www.gapminder.org/worldoffline/.)
GDP per capita isn’t a perfect measure of economic well-being, and it makes no
pretense of measuring human happiness. But it’s the most widely used measure
of the former, and it’s a rough indicator of the latter. On your exams I will expect
you to know how it is measured, and its strengths and weaknesses.
Mankiw Chapter 6, Measuring the Cost of Living
A. The Consumer Price Index (CPI)
The Consumer Price Index, or CPI, is a measure of the dollar cost of living. More
accurately, it measures the value of a typical dollar for a typical urban consumer
living in a typical city in the United States. The higher the CPI, the less valuable
that dollar is for purchasing the goods and services needed in daily life.
The CPI has been calculated since January 1913, at which point its value was
9.8. In January 2013 it stood at 230.3, implying that consumer prices are roughly
23 times higher now than they were 100 years ago. Equivalently, since 9.8 is just
4% of 230.3, we could say that according to the CPI the dollar lost about 96% of
its value in 100 years. This is not as bad as it sounds, since wages increased
even more than prices over this period, so workers are much better able to pay
2013’s high prices than they were to pay 1913’s low prices.
You can find the full CPI data set at ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt.
Answers to frequently asked questions about the CPI’s calculation are at
http://stats.bls.gov/cpi/cpifaq.htm.
Calculating the CPI. The Bureau of Labor Statistics (BLS) in Washington, DC
calculates the CPI every month. It is the cost of a “market basket” of goods and
services that consumers typically purchase each month.
First, the BLS needs to know what consumers buy. To find out, it asks about
7000 families to find out what they buy, using the Consumer Expenditures
Survey. From this survey, the BLS constructs what it calls a “market basket”
containing about 200 specific goods and services. The market basket contains
everything from peanut butter to doctors’ services to apartment rents to car repair
to movie tickets to clothing to cell phones.
Next, the BLS needs the prices that consumers pay. It surveys 23,000 retail and
service establishments and 50,000 landlords in almost 90 locations across the
country to find out the prices of the items in the market basket.
Then the BLS computes the cost of the “market basket” at the current month’s
prices. That is, the BLS pretty much does the same thing with its “market basket”
that the Kroger checker does with your basket of groceries when you check out.
It multiplies the price of each item times the amount purchased, and adds up the
price of the basket as a whole.
Finally, the BLS calculates the Consumer Price Index by relating the current cost
of the market basket to the cost of the basket in a “base year.” Thus,
Cost of the market basket in 2014
CPI2014 = Cost of the market basket in the base year x 100
To see how this formula can be used in practice, let’s look at a specific example
of a market basket containing just two items. See if you can fill in the blanks for
the cost of the basket and CPI, using 2013 as the base year.
Price
of
Coffee
Quantity of
Coffee
Consumed
Price of
Doughnuts
Q of
Donuts
Consumed
2012
$ .50
20
$1.00
10
2013 (base)
$ .75
20
$1.50
10
2014
$ 1.25
20
$1.00
10
Year
Cost of
Basket
CPI
Inflation
Rate
To find the cost of the basket, just multiply prices and quantities and add. For
example, the cost of the 2012 basket was ($.50x20)+($1.00x10) = 10+10 = 20.
Price
of
Coffee
Quantity of
Coffee
Consumed
2012
$ .50
2013 (base)
2014
Year
Price of
Doughnuts
Q of
Donuts
Consumed
Cost of
Basket
20
$1.00
10
20
$ .75
20
$1.50
10
30
$ 1.25
20
$1.00
10
35
CPI
Inflation
Rate
To find the CPI for 2012, just divide the 2012 cost by the base year cost and
multiply by 100: (20/30)x100 = 33.3. Do the same for 2013 and 2014,
Price
of
Coffee
Quantity of
Coffee
Consumed
Price of
Doughnuts
Q of
Donuts
Consumed
Cost of
Basket
CPI
2012
$ .50
20
$1.00
10
20
33.3
2013 (base)
$ .75
20
$1.50
10
30
100.0
2014
$ 1.25
20
$1.00
10
35
116.7
Year
Inflation
Rate
Notice that the CPI in the base year is 100. Also, the CPI rises with the general
level of prices. Between 2013 and 2014 the price of coffee rose while the price of
doughnuts fell. The CPI rose from 2013 to 2014, though, because consumers
buy more doughnuts than coffee.
Computing the Inflation Rate The rate of inflation may be computed as the
annual rate of change in the CPI. A rate of change is always computed as a
change, divided by the value at the starting point. Therefore,
Inflation Rate for 2013 =
CPI2013  CPI2012
x 100
CPI2012
Plugging numbers into this formula, you should be able to fill in the last column
for 2013 and 2014 in the table above. The solution is below.
Price
of
Coffee
Quantity of
Coffee
Consumed
Price of
Doughnuts
Q of
Donuts
Consumed
Cost of
Basket
CPI
Inflation
Rate
2012
$ .50
20
$1.00
10
20
33.3
--
2013 (base)
$ .75
20
$1.50
10
30
100.0
200%
2014
$ 1.25
20
$1.00
10
35
116.7
16.7%
Year
Note that we couldn’t compute the inflation rate for 2012 because to do so we
would have needed to know the CPI for 2011. If, for example 2011’s CPI was 30,
the 2012 inflation rate would be (3.3/30)x100 = 11.1%.
Measurement Problems with the CPI
There are several practical problems with measuring the CPI, most of which tend
to cause changes in the CPI to overstate the rate of inflation. The BLS in fact
adjusts its calculations to try to deal with these problems, but they have no
perfect solution.
1. Substitution Bias: Quantities that a typical consumer will purchase will
change as relative prices change. Suppose the market basket consisted of
one pound of pears and one pound of apples. One day you go to Kroger and
find that both pears and apples cost $1.00 per pound, so the market basket
costs $2. The next month you go to the market and find that pears are $10
and apples are still $1, which is a relative increase in the price of pears. The
market basket now costs $11, implying an inflation rate of 450% per month!
But this is ridiculous. Any sensible shopper would respond to the increase in
the relative price of pears by buying fewer pears and more apples. The
shopper might buy two pounds of apples and no pears at all, so the price of
her market basket would in fact stay the same. Because the CPI relies on a
rigid definition of the market basket, it overstates the effect of relative price
changes on the inflation rate.
2. Introduction of New Goods and Services increases the value of a dollar.
Twenty years ago, you could not have bought a smart phone; even if you
had bought one, the internet hardly existed. One hundred years ago you
would not have been able to cure an eye infection that can be treated simply
today with antibiotics. Your dollar has gained new power to buy new products
that improve your standard of living, but the CPI has no easy way of taking
this fact into account. The CPI therefore overstates the inflation rate, which
after all is just a measure of the decline in a dollar’s purchasing power.
3. Changes in Quality. If you wanted to buy a computer in 1985, you could
have bought a very nice one for about $2000. If you spend $2000 on a
computer today, you could get one that is far more powerful and useful than
a million-dollar 1985 computer. Similarly, today’s houses are larger and more
comfortable, and today’s cars have many features that were unavailable 30
years ago. Their higher prices are partly attributable to their higher value, so
a CPI calculation based simply on prices would overstate the rate of inflation.
4. Volatility in data means that there is a lot of noise that distracts from the
underlying information content. Some prices, most notably food and energy
prices, are “noisier” than others. That is, they rise and fall with greater
frequency than other prices, and so can create a misleading picture of the
inflation rate. The BLS therefore constructs a measure of “Core” CPI that
excludes food and energy prices. This doesn’t mean that the Core CPI is
useful only to people who don’t buy food or gasoline! To take an extreme
example, consider the history of regular gasoline prices, the CPI, and the
Core CPI in 2008:
Date
1/1/2008
7/1/2008
1/1/2009
Gasoline
Price
$3.11
$4.11
$1.61
CPI
212
219
217
CPI
Change
3.2%
-.7%
Core CPI
214
216
220
Core CPI
Change
1.0%
2.1%
Gasoline prices increased temporarily by 32% from January to July 2008,
then declined by 61% from July through December with the onset of the
financial panic. The CPI, strongly influenced by gasoline prices, increased by
3.2% from January to July then declined from July through December. The
Core CPI ignored this change in gasoline prices and indicated a low rate of
inflation all year. You can see that the Core CPI ignores real changes in
consumer costs, but it can be useful to clear away temporary noise that can
exaggerate or attenuate the underlying rate of change in the value of a
dollar.
Differences Between the GDP Deflator and CPI
We have studied two indicators of the dollar’s value, the CPI and GDP Deflator.
They look at different sets of prices. The GDP looks only at prices of goods and
services produced in the United States, while the CPI looks only at prices paid by
consumers. Therefore, the prices of imports (Samsung TV sets, for example)
don’t directly affect the GDP deflator, but they do affect the CPI. Conversely, the
price of American rice exported to Asia affects the GDP deflator, but not the CPI.
Similarly, the price of American jet fighter planes, whether exported to Israel or
purchased by the Pentagon, affect the GDP deflator but not the CPI.
Also, the CPI and GDP deflator are calculated by different methods. Most
importantly, the CPI uses a fixed market basket that hardly ever changes, while
the GDP Deflator uses the total production of the U.S. economy, which changes
all the time.
Despite these differences, the GDP Deflator and the CPI move together, rising
and falling as the value of a dollar falls and rises, as indicated in the graph below.
Inflation rates as indicated by the CPI (blue) and GDP Deflator (red),
http://research.stlouisfed.org/fred2/graph/?id=CPIAUCSL,GDPDEF
Other Measures of Inflation can be found as well. These also use different
methods and measure prices of different goods and services, but they also
broadly agree with the CPI
1. The Producer Price Index (PPI) is computed the same way as the CPI, but
uses a market basket of inputs (land, labor, capital, and materials) purchased
by firms.
2. The Personal Consumption Expenditure (PCE) Index, like the CPI, attempts
to measure prices facing the U.S. consumer. Unlike the CPI, which is
compiled by the Bureau of Labor Statistics, it is compiled by the Bureau of
Economic Analysis. Its market basket changes more often, and the PCE
index often rises at a slightly lower rate than the CPI.
See http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm and
http://www.bea.gov/faq/index.cfm?faq_id=555
3. The Billion Prices Project (http://bpp.mit.edu/) is a new index collected
privately by researchers at the Massachusetts Institute of Technology. It
tracks prices of things that are sold or advertised on the internet, which
obviously leaves out a lot of things. It’s also gathered automatically, which
means that it can be calculated daily, so it can be used to anticipate nearterm changes in the CPI. It also tends to track the CPI rather closely, as you
can see here: http://www.pricestats.com/us-series.
B. Using the CPI to Correct Economic Measurements for Inflation
One of the primary uses of the CPI is to adjust economic measurements (of
wages, incomes, prices, etc.) for inflation, so as to make it possible to compare
those measurements from year to year. That is, we can use the CPI to convert
nominal (current-dollar) measures to real (constant-dollar) measurements.
For example, when I was a kid my father, who married in 1947, told me that
when he was a young man the rule of thumb was that one should make at least
$40 per week before getting married. That is, $40 per week (or $1.00 per hour,
about $2000 per year) was considered sufficient to buy a bare minimum of goods
and services required by a young married couple. Try that today, and you’ll
starve!
Obviously, it was not the custom in 1947 for a young couple to starve. $2000
(nominal income) bought a lot more goods and services (real income) in those
days than it does today. How much more? To answer that question, we’ll use the
CPI.
How to Convert Nominal Values to Real Values
The formula used to convert 1947 dollar income to, say, 2013 dollar income is
pretty simple:
CPI for 2013
2013 Dollar Income = (1947 Dollar Income) x CPI for 1947
Rounding off for easy computation, let’s say that the CPI for 2013 was 240 and
the CPI for 1947 was 40. Plugging in numbers, the 2013 equivalent for my
father’s 1947 minimum income of $2000 per year would be
240
2013 Dollar Income = $2000 x 40 = $2000 x 6 = $12,000
This is still a very low income by today’s standards. $12,000 today would cover
basic groceries and meager housing and little else, but people were poorer in
general in 1947 and $12,000 in 2013 dollars was therefore considered sufficient
for young people starting out in life. The point is that without converting to
standard dollars (in this case 2013 dollars) we would have no way to assess the
standard of living supported by $2,000 in 1947.
In the second column of the table below you can see a list of the current-dollar
(nominal) income earned over the career of a fictitious man who was born in
1927, started work in 1947, retired in 1992, and died in 2013. You should be able
to verify the values in the last two columns, using the conversion formula above.
Do it now!
Year
1947
1960
1970
1980
1990
2000
2013
Current
Dollar
CPI2013
Income
(Nominal) CPIYEAR CPIYear
$2000
40 6.00
$10,000
45 5.33
$40,000
50 4.80
$80,000
100 2.40
$100,000
125 1.92
$125,000
180 1.33
$80,000
240 1.00
2013
Dollar
Income
$12,000
$53,333
$192,000
$192,000
$192,000
$166,667
$80,000
1980
Dollar
Income
$5,000
$22,222
$80,000
$80,000
$80,000
$69,444
$33,333
Glancing over the nominal figures in the second column, it appears that the
man’s income increased steadily over his career, then declined during his late
retirement. It appears that the 1970’s were a very good decade for him, as his
income apparently doubled. But the last two columns tell a quite different story
(though they are consistent with each other). In reality, the man’s standard of
living advanced quickly during the 1950’s and 1960’s, but quit growing in 1970.
That is, his nominal income simply kept pace with inflation between 1970 and
1990. His real income declined during his retirement years, especially during his
late retirement after the year 2000.
Notice that, though the numbers are different, the ups and downs of the man’s
real income appear the same whether his real income is calculated in 2013
dollars or base-year (1980) dollars. To compare real income from one year to the
next, use the same base year for all calculations.
Indexation
Many real-world values are computed using the CPI. For example, many union
contracts specify that wages will increase with the rate of inflation as calculated
with the CPI, a so-called Cost of Living Adjustment or COLA. Social Security
payments use similar COLAs, as are the tax brackets used to calculate marginal
income tax rates. Minimum wage rates, however, are set directly by Congress
and do not use COLAs.
Real and Nominal Interest Rates
When you take out a loan or deposit your money in a savings account, you are
quoted an interest rate. That is a nominal interest rate, expressed as a
percentage of the amount loaned or deposited. Thus, if you borrow $1000 (the
“principal”) at an annual percentage rate of 10%, you pay 10% of $1000, or $100
per year for the loan. Your nominal rate of interest is 10%. When you pay back
the $1000, perhaps years later, the loan is completed.
If there is inflation during the course of the loan, though, the real value the dollar
payments falls. Therefore the $1000 that you pay back years later is worth less
than the $1000 you originally borrowed, and each of your yearly $100 payments
is worth less than the previous one. It is a simple matter to compute the “real”
interest rate if you know the inflation rate and the nominal interest rate:
Real Interest Rate = (Nominal Interest Rate) – (Inflation Rate)
Thus if you borrow at a nominal rate of 10% and the inflation rate is 3%, the real
interest you pay is 10% - 3% = 7%.
What’s good for you as a borrower is bad for you as a lender. Your savings
account, for example, is a loan you are making to the bank. If you have a savings
account that pays 1% nominal and the inflation rate is 3%, your money is actually
losing value faster than it is accumulating. Said another way, you are earning a
negative real interest rate. To be exact, your real interest rate is 1% - 3% = -2%.
That is, if you deposited $1000 at a nominal 1%, after one year you will have
$1010 in your account ($1000 principal plus $10 interest). But because of
inflation you’ll be able to buy 2% less in real goods and services with that $1010
at the end of the year than you could have bought with $1000 at the beginning of
the year. As of 2013, most banks are paying negative real interest rates on
savings accounts.
For borrowers, inflation reduces the real cost of borrowing.
For lenders, inflation reduces the real return from lending.
Measuring Unemployment
Mankiw Chapter 10, first section, “Identifying Unemployment”)
Unemployment occurs when a person who wants to work is unable to find a job.
Unemployment is a personal frustration, a hardship for a family, and a waste of
society’s resources. An hour of labor, if not performed, can never be recovered.
Beyond that, a person who is unemployed loses the skills and experiences that
are gained during work, loses self-respect, becomes less employable week by
week as unemployment persists.
The unemployment rate is a key measure of the health of the macroeconomy. It’s
in the news pretty constantly, and it affects your life directly. If you graduate from
college when the unemployment rate is high, it will be harder for you to find your
first job, that first job will pay less, and you’ll probably make less money for the
rest of your career. The details of how we measure unemployment matter
because it’s easy to misinterpret the statistics we see in the newspaper.
The Current Population Survey is the instrument by which the federal Bureau
of Labor Statistics (BLS) measures the current condition of the labor force. Every
month, workers from the BLS survey 60,000 households and seek the answers
to two key questions:
1) Did you work for pay during the past week?
2) If not, did you actively look for a job in the past four weeks?
If the answer to question 1) is yes, the person is classified as EMPLOYED.
If the answer to question 1) is no and the answer to question 2) is yes, the
person is classified as UNEMPLOYED.
If the answers to both question 1) and question 2) are no, the person is classified
as NOT IN THE LABOR FORCE. Many students, and nearly all retired people, for
example, are not in the labor force.
Thus, to be counted as unemployed, a person must both 1) not be employed and
2) looking for a job. Unemployed and employed people are both counted as “in
the labor force” (ILF).
There are a few details you must know about how the labor force is counted.
First, people who are self-employed are counted as employed. Also, people who
are working in a family business but not paid regular wages are employed.
People working part-time (whether they would prefer full-time work or not) are
counted as employed. People working full-time at volunteer work not for pay are
NOT employed (for example, stay-at-home moms and dads are not employed).
These volunteers will be counted in the labor force (ILF) only if they are also
actively looking for paid work, in which case they will count as unemployed.
Someone who would like a job but has given up looking is NOT unemployed
because he is not in the labor force.
People in the military are not in the labor force. The same is true of people who
are in hospitals or prisons.
Calculating the Unemployment Rate
Based on the answers to these two questions the BLS calculates the
unemployment rate (“U-3”) as follows:
Number In the Labor Force = (Number Employed) + (Number Unemployed).
Number Unemployed
Unemployment Rate (U-3) = Number In the Labor Force x 100
So, for example, the imaginary country of Stratumbria contains 80 million people
working for pay, 20 million people not employed but actively looking for jobs, 30
million retired people, and 10 million full-time students who are not working or
looking for jobs. This economy would have a labor force of 80 + 20 = 100 million,
and an unemployment rate of (20 million unemployed / 100 million ILF) x 100 =
20%.
You should study this formula until you understand it fully.
Alternative measures of Unemployment ()
The unemployment rate in the formula above has its critics. In many ways it
underestimates the pain caused by lack of employment opportunity. For
example, suppose that Sharon was an auto worker in Michigan until the local
Chrysler plant shut down last year. Since then she has been unable to find a job,
and after months of fruitless search for a job she simply gives up looking. While
she was looking for a job Sharon was unemployed and in the labor force. Once
she gave up looking she was no longer counted as either unemployed or in the
labor force. Mathematically, by leaving the labor force Sharon lowered the
unemployment rate. Does that seem right?
Now consider the case of Anthony, who has a mechanical engineering degree
but has been unable to find work in his field. He decides to take a part time job
delivering pizzas while he looks for a job. He’s employed and therefore in the
labor force, and the underemployment of his skills is not measured in the
unemployment rate. Does that seem right?
Well, like most statistics the unemployment rate is an imperfect measure. The
BLS recognizes this, and so it calculates six different unemployment rates, which
it calls U-1 through U-6. You can find a table describing them and their current
values at http://www.bls.gov/news.release/empsit.t15.htm. Click through and take
a long look at this table. The one whose formula I gave you to memorize just
above is called U-3. Find it in the table and memorize the current value of U-3.
You’ll be expected to know it on the exam.
You don’t have to memorize formulas for any of the unemployment measures
except U-3, but should be familiar with U-6, as it is the second most commonly
quoted unemployment rate in the news. Note that U-6 is much higher than U-3
because it counts discouraged workers like Sharon, involuntarily part-time
workers like Anthony, and some other classes of people who are experiencing
problems finding jobs. Note that most of the difference between U-3 and U-6 is
due to workers such as Anthony, and relatively few are discouraged workers like
Sharon. Memorize the current value of U-6 as well as U-3.
The Labor Force Participation Rate is another key measure of the current state
of the labor force. The BLS uses data from the Current Population Survey to
calculate this statistic as well.
Number In the Labor Force
Labor Force Participation Rate = Adult Civilian Population x 100
By “adult” the BLS means people 16 years of age or older. By “Civilian” the BLS
means people who are not in the military or in hospitals or prisons. If an
increasing percentage of the adult civilian population joins the labor force, the
economy will be able to produce more goods and services, and there will be
more for all of us to consume.
Labor Force Participation of Men (top), Women (bottom), and Overall (middle), 1947
– 2013
The chart above shows one aspect of how the labor force has changed since
1947. The top line is men’s labor force participation. It is higher than women’s,
but has declined pretty steadily since 1947, in part because the number of older
men (who have low labor force participation rates) has increased, in part
because the share of younger men staying in school or otherwise out of the labor
force in jail, for instance) has increased. Note that men’s participation rate also
varies over a yearly cycle, as many men work in seasonal occupations such as
construction.
Women steadily increased their participation in the labor force from the end of
World War II through the late 1990s. Their rate of participation accelerated a bit
during the women’s movement of the 1970’s, but that movement did not begin
the trend; rather, the reverse is most likely true.
Overall, labor force participation rose through the 1970s and 1980s as women
and baby boomers (people born between 1946 and 1964) entered the work
force. Participation has begun to decline as the boomers have begun to reach
retirement age. The economic collapse and recession of 2007-2010 appears to
have accelerated this decline in labor force participation.
Cyclical Unemployment and the Natural Rate.
The unemployment rate varies over the business cycle, increasing during
recessions (gray areas in the graph below) and decreasing during economic
recoveries. For the past 50 years the unemployment rate in the U.S. has
averaged around 6%, though it has fallen below 4% during the booms of the
1960s and 1990s, and as high as 10.8% in November 1982 and 10% in October
2009.
Unemployment Rate (U-3, blue) and the Natural Rate of Unemployment (Red)
http://research.stlouisfed.org/fred2/graph/?id=UNRATE,NROU
The rate around which the unemployment rate fluctuates is called the Natural
Rate of Unemployment. It’s “natural” in the sense that it’s the unemployment rate
when the economy is neither depressed nor booming excessively. The Natural
Rate may vary with the nature of industry and the labor force at any given time,
but it generally lies between 5% and 6%, as shown by the red line in the graph
above.
Because any deviation from the Natural Rate is caused by the business cycle,
the difference between the current rate of unemployment and the natural rate is
referred to as Cyclical Unemployment. For example, in August 2013 the current
rate of unemployment was 7.4% and the Natural Rate was at 5.5%, so cyclical
unemployment was 7.4  5.5 = 1.9%.
Cyclical unemployment can be negative when the economy is in an excessive
boom. For example, in December 2000, during the closing phase of the “dotcom
boom,” the unemployment rate reached 3.9%. The Natural Rate in December
2000 was about 5%, so cyclical unemployment was negative1.1%.
Discussion Question(s):
Put your discussion question(s) for this module in this box. They should be short conversationstarters. Include the question(s) the students must reply to, and include instructions as well.
Instructions. Each of the questions below will be the subject of a threaded
discussion. Threaded discussions are graded on the basis of participation. You must
contribute at least two substantive remarks to the discussions in this module to get
one point.
1. In the year 2011 the prices at which producers sold their output were quite
real to those producers. If they had tried to sell their products at 1983 prices
their customers and stockholders would have rightly thought the producers
had lost touch with reality. Why, then, would an economist calculate the value
of 2011 output at 1983 prices and call it “real" GDP?
2. Robert F. Kennedy’s remarks about GNP (which is similar to GDP) measuring
everything except the things that really matter are often taken to mean that
GDP is a worthless and misleading measure. Can it be used to mislead?
Make up an example of how a politician could interpret an increase in GDP in
a misleading way to claim an increase in economic well-being when
economic well-being was in fact declining. Can we address Kennedy’s
objections to GDP by using Real GDP instead of Nominal GDP?
3. Suppose that you were in charge of calculating the CPI as part of your job at
the Bureau of Economic Analysis. Given each of the following facts, would
each of the following facts tend to cause the CPI to overstate or understate
the rate of inflation? Would you adjust your measure of the CPI in response?
If so how, exactly?
a. You find that over the past ten years the rent on a typical apartment
has risen from $800 to $1000 and the size of a typical apartment has
increased from 1000 square feet to 1200 square feet.
b. You find that the price of a cellphone contract has stayed the same,
but most cellphone carriers have removed restrictions and extra
charges based on roaming.
c.
You find that the price of a personal computer has fallen by 10%, but
the typical PC has a much better monitor and much more computing
power.
d. The price of a light bulb has tripled, but the typical light bulb now uses
only one-third the electricity as before.
4. The cyclical rate of unemployment can be negative, which implies that the
business cycle sometimes produces too little unemployment. How can there
be “too little” unemployment for the health of the economy?
5. The country of Elbonia recently consisted of 20 million people in its adult noninstitutionalized population, 8 million people employed, and 2 million
unemployed, for an unemployment rate (U-3) of 10% and a labor force
participation rate of 50%. Then one million of the unemployed became
discouraged about ever being able to find a job and quit looking. When the
one million quit looking for jobs, did the unemployment rate (U-3) in Elbonia
rise or fall? Did the Elbonian labor force participation rate rise or fall? Did
Elbonian U-6 rise, fall, or remain the same? In the U.S. in 2013 U-3, U-6, and
the labor force participation rate all fell. Do you think the labor market in the
U.S. in 2013 was improving, or do you have doubts? Explain. Does
consideration of any one of these three statistics tell you all you need to know
about the health of the U.S. labor market? Why do you think the media (and
economists as well) tend to focus on just one statistic, U-3?

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