GDP, Real GDP, and the Cost of Living

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GDP, Real GDP, and the Cost of Living
ECO 105 Lecture 3.4 20 October 2008
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GDP and Price Movements

• GDP is the sum of P x Q for all final goods and
  services.
• Example Simple 3-good economy
• If prices rise,

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Real GDP

• How can we measure changes in actual production?
• We must use prices we need
• The solution Use
• Example
• Real GDP is GDP in

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Base Year 2000
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When RGDP growth is negative, the economy is in
recession.
When RGDP growth is negative, the economy is in
recession.
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The GDP Deflator

• A measure of the general level of prices,
  compared to
• GDP deflator
• Example 215,700/202,500
• 1.065 x

x
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The Cost of Living

• Prices change over time
• The GDP deflator measures price changes
• . . . but it also measures
• and omits
• The cost of living is better captured by

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The Consumer Price Index

• Focuses on a basket of goods and services

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Calculating the CPI

• 1. Determine the goods in the market basket.
• 2. Find
• 3. Compute
• 4. Choose a base year
• Work the example on your handout.

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Inflation

• Percentage change
• (CPI2/CPI1) - 1 x 100
• Calculate inflation on your handout.
• Even when the CPI is rising,
• Relative prices

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CPI and GDP Deflator

• Two main differences
• Different baskets
• CPI uses fixed quantity weights deflator uses

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Problems with the CPI

• Substitution bias consumers react to changes
• Introduction of
• Improvements in
• The CPI overstates inflation -

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Making Sense of Your First Job Offer

• Congratulations! Now, which offer do you accept?
• New York City at 60,000?
• Houston at 55,000?
• Suppose the New York CPI is 182, while Houstons
  is 155. Which offer is better?
• In price-adjusted dollars,

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Correcting for Inflation

• Suppose Stan Musial and Ernie Banks each earned
  100,000 in 1963.
• If the CPI in 1963 was 30.2 (in 2000 dollars) and
  in 2008 is 208.6, how do their salaries compare
  to todays stars?
• 100,000 x (208.6/31.0) converts the 1963
  salaries to 2008 terms.
• 672,903 is less than bench jockeys earn.

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Indexation

• Some payments rise
• E.g., social security payments income-tax
  brackets
• Some union contracts link wages to the CPI

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Nominal and Real Interest Rates

• Is 7 a good rate of return?
• Nominal (market) interest rate is in
• Real interest rate is in
• Real interest rate