7.

Measuring a Nation’s Income;

Measuring the Cost of Living
 Measuring a Nation’s Income
• Microeconomics
• Microeconomics is the study of how individual
households and firms make decisions and how they
interact with one another in markets.
• Macroeconomics
• Macroeconomics is the study of the economy as a
whole.
• Its goal is to explain the economic changes that
affect many households, firms, and markets at once.
 Measuring a Nation’s Income
• Macroeconomics answers questions like the
following:
• Why is average income high in some countries and
low in others?
• Why do prices rise rapidly in some time periods
while they are more stable in others?
• Why do production and employment expand in
some years and contract in others?
 THE ECONOMY’S INCOME AND
EXPENDITURE
• When judging whether the economy is doing
well or poorly, it is natural to look at the total
income that everyone in the economy is
earning.
• For an economy as a whole, income must equal
expenditure because:
• Every transaction has a buyer and a seller.
• Every dollar of spending by some buyer is a dollar
of income for some seller.
Figure 1 The Circular-Flow Diagram

MARKETS
Revenue FOR Spending
GOODS AND SERVICES
•Firms sell Goods and
Goods
•Households buy services
and services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services goods and services
•Hire and use factors •Own and sell factors
of production of production

Factors of MARKETS Labor, land,

production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, •Households sell Income
and profit •Firms buy
= Flow of inputs
and outputs
= Flow of dollars

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THE MEASUREMENT OF GROSS
DOMESTIC PRODUCT
• Gross domestic product (GDP) is a measure of
the income and expenditures of an economy.
• It is the total market value of all final goods and
services produced within a country in a given
period of time.
• The equality of income and expenditure can be
illustrated with the circular-flow diagram.
 THE MEASUREMENT OF GROSS
DOMESTIC PRODUCT
• GDP is the market value of all final goods and
services produced within a country in a given
period of time.
• “GDP is the Market Value . . .”
• Output is valued at market prices.
• “. . . Of All Final . . .”
• It records only the value of final goods, not intermediate
goods (the value is counted only once).
• “. . . Goods and Services . . . “
• It includes both tangible goods (food, clothing, cars) and
intangible services (haircuts, housecleaning, doctor visits).
 THE MEASUREMENT OF GROSS
DOMESTIC PRODUCT
• “. . . Produced . . .”
• It includes goods and services currently produced, not
transactions involving goods produced in the past.
• “ . . . Within a Country . . .”
• It measures the value of production within the geographic
confines of a country.
• “. . . In a Given Period of Time.”
• It measures the value of production that takes place within a
specific interval of time, usually a year or a quarter (three
months).
 THE COMPONENTS OF GDP
• GDP includes all items produced in the
economy and sold legally in markets.
• What Is Not Counted in GDP?
• GDP excludes most items that are produced and
consumed at home and that never enter the
marketplace.
• It excludes items produced and sold illicitly, such as
illegal drugs.
 THE COMPONENTS OF GDP
• GDP (Y) is the sum of the following:
• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)
Y = C + I + G + NX
 THE COMPONENTS OF GDP
• Consumption (C):
• The spending by households on goods and services, with the
exception of purchases of new housing.
• Investment (I):
• The spending on capital equipment, inventories, and structures,
including new housing.
• Government Purchases (G):
• The spending on goods and services by local, state, and federal
governments.
• Does not include transfer payments because they are not made in
exchange for currently produced goods or services.
• Net Exports (NX):
• Exports minus imports.
Table 1 GDP and Its Components

Copyright©2004 South-Western
 GDP and Its Components (2001)

Government
Purchases
Investment 18% Net Exports
16% -3 %

Consumption
69%
 REAL VERSUS NOMINAL GDP
• Nominal GDP values the production of goods
and services at current prices.
• Real GDP values the production of goods and
services at constant prices.
• An accurate view of the economy requires
adjusting nominal to real GDP by using the
GDP deflator.
Table 2 Real and Nominal GDP

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Table 2 Real and Nominal GDP

Copyright©2004 South-Western
Table 2 Real and Nominal GDP

Copyright©2004 South-Western
The GDP Deflator

• The GDP deflator is a measure of the price

level calculated as the ratio of nominal GDP to
real GDP times 100.
• It tells us the rise in nominal GDP that is
attributable to a rise in prices rather than a rise
in the quantities produced.
The GDP Deflator

• The GDP deflator is calculated as follows:

N o m in al G D P
G D P d eflato r =  100
R eal G D P
The GDP Deflator

• Converting Nominal GDP to Real GDP

• Nominal GDP is converted to real GDP as follows:

N o m in al G D P2 0 X X
R eal G D P 2 0 X X   100
G D P d eflato r2 0 X X
Table 2 Real and Nominal GDP

Copyright©2004 South-Western
 Figure 2 Real GDP in the United States

Billions of
1996 Dollars
$10,000

9,000

8,000

7,000

6,000

5,000

4,000

3,000
1970 1975 1980 1985 1990 1995 2000

Copyright © 2004 South-Western

 GDP AND ECONOMIC WELL-
BEING
• GDP is the best single measure of the economic
well-being of a society.
• GDP per person tells us the income and
expenditure of the average person in the
economy.
• Higher GDP per person indicates a higher
standard of living.
• GDP is not a perfect measure of the happiness
or quality of life, however.
 GDP AND ECONOMIC
WELL-BEING
• Some things that contribute to well-being are
not included in GDP.
• The value of leisure.
• The value of a clean environment.
• The value of almost all activity that takes place
outside of markets, such as the value of the time
parents spend with their children and the value of
volunteer work.
Table 3 GDP, Life Expectancy, and Literacy

Copyright©2004 South-Western
 Measuring the Cost of Living
• Inflation refers to a situation in which the
economy’s overall price level is rising.
• The inflation rate is the percentage change in
the price level from the previous period.
 THE CONSUMER PRICE INDEX
• The consumer price index (CPI) is a measure of
the overall cost of the goods and services
bought by a typical consumer.
• The Bureau of Labor Statistics reports the CPI
each month.
• It is used to monitor changes in the cost of
living over time.
• When the CPI rises, the typical family has to
spend more dollars to maintain the same
standard of living.
How the Consumer Price Index Is Calculated

• Fix the Basket: Determine what prices are

most important to the typical consumer.
• The Bureau of Labor Statistics (BLS) identifies a
market basket of goods and services the typical
consumer buys.
• The BLS conducts monthly consumer surveys to set
the weights for the prices of those goods and
services.
• Find the Prices: Find the prices of each of the
goods and services in the basket for each point in
time.
How the Consumer Price Index Is Calculated

• Compute the Basket’s Cost: Use the data on

prices to calculate the cost of the basket of
goods and services at different times.
• Choose a Base Year and Compute the Index:
• Designate one year as the base year, making it the
benchmark against which other years are compared.
• Compute the index by dividing the price of the
basket in one year by the price in the base year and
multiplying by 100.
How the Consumer Price Index Is Calculated

• Compute the inflation rate: The inflation rate

is the percentage change in the price index from
the preceding period.
• The Inflation Rate
• The inflation rate is calculated as follows:

C P I in Y ear 2 - C P I in Y ear 1
In flatio n R ate in Y ear 2 =  100
C P I in Y ear 1
Table 1 Calculating the Consumer Price Index and the
Inflation Rate: An Example

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Table 1 Calculating the Consumer Price Index and the
Inflation Rate: An Example

Copyright©2004 South-Western
Table 1 Calculating the Consumer Price Index and the
Inflation Rate: An Example

Copyright©2004 South-Western
Table 1 Calculating the Consumer Price Index and the
Inflation Rate: An Example

Copyright©2004 South-Western
How the Consumer Price Index Is Calculated

• Calculating the Consumer Price Index and the

Inflation Rate: Another Example
• Base Year is 2002.
• Basket of goods in 2002 costs $1,200.
• The same basket in 2004 costs $1,236.
• CPI = ($1,236/$1,200)  100 = 103.
• Prices increased 3 percent between 2002 and 2004.
FYI: What’s in the CPI’s Basket?

16%
Food and
beverages

17% 41%
Transportation Housing

Education and
6%
communication 6%
6% 4% 4%

Medical care
Other goods
Recreation Apparel and services
Copyright©2004 South-Western
Problems in Measuring the Cost of Living

• The CPI is an accurate measure of the selected

goods that make up the typical bundle, but it is
not a perfect measure of the cost of living.
• Substitution bias
• Introduction of new goods
• Unmeasured quality changes
Problems in Measuring the Cost of Living

• Substitution Bias
• The basket does not change to reflect consumer
reaction to changes in relative prices.
• Consumers substitute toward goods that have become
relatively less expensive.
• The index overstates the increase in cost of living by not
considering consumer substitution.
Problems in Measuring the Cost of Living

• Introduction of New Goods

• The basket does not reflect the change in
purchasing power brought on by the introduction of
new products.
• New products result in greater variety, which in turn
makes each dollar more valuable.
• Consumers need fewer dollars to maintain any given
standard of living.
Problems in Measuring the Cost of Living

• Unmeasured Quality Changes

• If the quality of a good rises from one year to the
next, the value of a dollar rises, even if the price of
the good stays the same.
• If the quality of a good falls from one year to the
next, the value of a dollar falls, even if the price of
the good stays the same.
• The BLS tries to adjust the price for constant
quality, but such differences are hard to measure.
Problems in Measuring the Cost of Living

• The substitution bias, introduction of new

goods, and unmeasured quality changes cause
the CPI to overstate the true cost of living.
• The issue is important because many government
programs use the CPI to adjust for changes in the
overall level of prices.
• The CPI overstates inflation by about 1 percentage
point per year.
The GDP Deflator versus the Consumer
Price Index
• The GDP deflator is calculated as follows:

N o m in al G D P
G D P d eflato r =  100
R eal G D P
The GDP Deflator versus the Consumer
Price Index
• The BLS calculates other prices indexes:
• The index for different regions within the country.
• The producer price index, which measures the cost
of a basket of goods and services bought by firms
rather than consumers.
The GDP Deflator versus the Consumer
Price Index
• Economists and policymakers monitor both the
GDP deflator and the consumer price index to
gauge how quickly prices are rising.
• There are two important differences between
the indexes that can cause them to diverge.
The GDP Deflator versus the Consumer
Price Index
• The GDP deflator reflects the prices of all
goods and services produced domestically,
whereas...
• …the consumer price index reflects the prices
of all goods and services bought by consumers.
The GDP Deflator versus the Consumer
Price Index
• The consumer price index compares the price
of a fixed basket of goods and services to the
price of the basket in the base year (only
occasionally does the BLS change the basket)...
• …whereas the GDP deflator compares the price
of currently produced goods and services to the
price of the same goods and services in the base
year.
Figure 2 Two Measures of Inflation

Percent
per Year
15

CPI

10

5
GDP deflator

0
1965 1970 1975 1980 1985 1990 1995 2000
Copyright©2004 South-Western
 CORRECTING ECONOMIC VARIABLES
FOR THE EFFECTS OF INFLATION
• Price indexes are used to correct for the effects
of inflation when comparing dollar figures from
different times.
Table 2 The Most Popular Movies of All Times,
Inflation Adjusted

Copyright©2004 South-Western
Indexation

• When some dollar amount is automatically

corrected for inflation by law or contract, the
amount is said to be indexed for inflation.
Real and Nominal Interest Rates

• Interest represents a payment in the future for a

transfer of money in the past.
• The nominal interest rate is the interest rate
usually reported and not corrected for inflation.
• It is the interest rate that a bank pays.
• The real interest rate is the nominal interest
rate that is corrected for the effects of inflation.
Real and Nominal Interest Rates

• You borrowed $1,000 for one year.

• Nominal interest rate was 15%.
• During the year inflation was 10%.
Real interest rate = Nominal interest rate –
Inflation
= 15% - 10% = 5%
 Figure 3 Real and Nominal Interest Rates

Interest Rates
(percent
per year)
15

10 Nominal interest rate

Real interest rate

–5
1965 1970 1975 1980 1985 1990 1995 2000
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 Summary
• Because every transaction has a buyer and a
seller, the total expenditure in the economy
must equal the total income in the economy.
• Gross Domestic Product (GDP) measures an
economy’s total expenditure on newly
produced goods and services and the total
income earned from the production of these
goods and services.

Copyright © 2004 South-Western

 Summary
• GDP is the market value of all final goods and
services produced within a country in a given
period of time.
• GDP is divided among four components of
expenditure: consumption, investment,
government purchases, and net exports.
 Summary
• Nominal GDP uses current prices to value the
economy’s production. Real GDP uses constant
base-year prices to value the economy’s
production of goods and services.
• The GDP deflator—calculated from the ratio of
nominal to real GDP—measures the level of
prices in the economy.
 Summary
• GDP is a good measure of economic well-being
because people prefer higher to lower incomes.
• It is not a perfect measure of well-being
because some things, such as leisure time and a
clean environment, aren’t measured by GDP.
 Summary

• The consumer price index shows the cost of a

basket of goods and services relative to the cost
of the same basket in the base year.
• The index is used to measure the overall level
of prices in the economy.
• The percentage change in the CPI measures the
inflation rate.
 Summary
• The consumer price index is an imperfect
measure of the cost of living for the following
three reasons: substitution bias, the
introduction of new goods, and unmeasured
changes in quality.
• Because of measurement problems, the CPI
overstates annual inflation by about 1
percentage point.
 Summary
• The GDP deflator differs from the CPI because
it includes goods and services produced rather
than goods and services consumed.
• In addition, the CPI uses a fixed basket of
goods, while the GDP deflator automatically
changes the group of goods and services over
time as the composition of GDP changes.
• The real interest rate equals the nominal interest
rate minus the rate of inflation.