Chapter 5

Macroeconomics the Big Picture

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Gross Domestic Product In simple terms, GDP is the total

output produced in an economy It is often used to measure:

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The size of an economy USA: 14.59 trillion

Japan: 4.91 trillion

Germany: 3.65 trillion

The performance of an economy

US GDP shrunk by 4% in the 3rd quarter of 2009

US GDP grew by 2% in the 1st

quarter of 2010

Standard of living in an economy

Commonly measured by per capital GDP

2008 GDPs

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Gross Domestic Product Formal definition: Nominal GDP

Total value of all final goods and services produced in an economy in given year valued at the current price

Real GDP

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Total value of all final goods and services produced in an economy in given year valued at the current price

Total value of all final goods and services produced in an economy in given year adjusted to eliminate the effect of price change

final

current price

adjusted to eliminate the effect of price change

Nominal and Real GDP Consider the following table

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Nominal GDP in 2008

Goods and Services

2008 2009

P Q P Q

Text Book 100 500

Hair Cuts 10 400

100 X 500 + 10 X 400 = 54,000

Nominal and Real GDP

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Nominal GDP in 2008

Goods and Services

2008 2009

P Q P Q

Text Book 100 500 150 400

Hair Cuts 10 400 15 300

100 X 500 + 10 X 400 = 54,000

Nominal GDP in 2009

150 X 400 + 15 X 300 = 64,500

Nominal and Real GDP

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Real GDP in 2008

Goods and

Services

2008 2009 1985

P Q P Q P

Text Book 100 500 150 400 75

Hair Cuts 10 400 15 300 5

75 X 500 + 5 X 400 = 39,500

Real GDP in 2009

75 X 400 + 5 X 300 = 31,500

Business Cycle Economy does not grow at a

constant rate Rather, it has a cyclical pattern,

which can be described by following components:

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Expansion

Recession

Peak

Trough

Business Cycle

An expansion is a sustained period in which real GDP is rising.

A recession is a sustained period in which real GDP is falling.

A peak is the point of the business cycle at which an expansion ends and a recession begins.

A trough is the point of the business cycle at which a recession ends and an expansion begins.

Business Cycle

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U.S. Real GDP

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Changes in Price Level

Price Levels are different from Price we learned in chapter 3

It is NOT the price of apple, orange or banana

It is the average price of all goods and services in an economy

Usually, measured by a basket of representative goods and services

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Changes in Price Level

For example CPI or Consumer Price Index tracks the prices of goods and services purchased by a typical urban family of four.

When price level rises, we call this Inflation

When price level falls, we call this deflation

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Inflation in the U.S.

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Impacts of Inflation

Unanticipated inflation has following adverse impacts:

Fall of purchasing power Redistributes wealth Creates uncertainty Hurts lenders and benefits

borrowers

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Impacts of deflation

Unanticipated deflation has following adverse impacts:

Redistributes wealth Creates uncertainty Hurts borrowers and benefits

lenders

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Computation of CPI

Price Index is a number whose movement reflects the changes in average price level

In any index system, we select a base period and compare the changes in price levels from the base period

Typically, indexing is done in such a way that,

Price Index for the Base Period= 100

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Computation of CPI Lets assume that Base period is 1985.

So, CPI1985 = 100

Now, if I tell you that CPI2000 = 150 What can we say about price level in

2000? Clearly, price level has increased from 1985 Therefore, economy observed inflation By how much? It is 50% compared to the base year This is the advantage of indexing to 100

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Another Example Lets assume again, CPI1985 = 100

Now, if I tell you that CPI2005 = 160 What can we say about price level in

2005? Again, price level has increased from 1985 Therefore, economy observed inflation By how much? It is 60% compared to the base year Can we say anything about inflation

compared to 2000 (CPI2000=150)?

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Another Example To compute inflation compared to non-

base years, we need some simple computations

Note we have, CPI1985 = 100 CPI2000 = 150 CPI2005 = 160 We like to know how price level had changed

form 2000 to 2005 Again looks like its an inflation. But how

much? We want to know, 150 to 160 is an increase

of how many percentage points?Hossain: MSMC 20

Percentage Computation All percentage computations, use the

same formula:

So, computing percentage change in CPI from 2000 (150) to 2005 (165)

160 – 150 150

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NEW OLD

OLDX 100

X 100 = 6.67%

In class Exercise Assume,

CPI1985 = 100 CPI1975 = 88 CPI2002 = 138 Compute the inflation rate in 1975

compared to the base year Compute the inflation rate in 2002

compared to the base year Compute the inflation rate in 2002

compared to 1975 Note inflation rate means percentage

change in CPIHossain: MSMC 22

Construction of CPI BLS surveys, computes and publishes CPI

To compute CPI, we first compute the Cost of basket (COB)

Here, COB2000 =10x4 + 15x1 + 2x3 = 61

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Price Data

Goods and Services Market Basket 2000Price

1985 Price

Apple 10 pounds $4.00 $2.00

Banana 15 pounds $1.00 $0.50

Cat food 2 bags $3.00 $0.25

Construction of CPI

Here, COB2000 =10x4 + 15x1 + 2x3 = 61

Here, COB1985 =10x2 + 15x.50 + 2x.25 = 28

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Price Data

Goods and Services Market Basket 2000Price

1985 Price

Apple 10 pounds $4.00 $2.00

Banana 15 pounds $1.00 $0.50

Cat food 2 bags $3.00 $0.25

Formula for CPI Use COB numbers to the formula for

CPI

Using this formula compute CPI of 1985 (the base year) CPI of 2000

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CPI xxxx =COBxxxx

COBBaseYear

X 100