Principles of Economics

Global Edition

Chapter 22
Unemployment, Inflation, and
Long-Run Growth

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

Chapter Outline and Learning
Objectives (1 of 2)
22.1 Unemployment
• Explain how unemployment is measured.
22.2 Inflation and Deflation
• Describe the tools used to measure inflation and discuss
the costs and effects of inflation.
22.3 Long-Run Growth
• Discuss the components and implications of long-run
growth.
Looking Ahead

Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

 The Macro Economy

DETERMINANTS OUTCOMES

Jobs
Internal market
forces
Prices

MACRO
External shocks Growth
ECONOMY
Output
Policy levers
International
balances
 Look for the answers to these questions:
• What is the Consumer Price Index (CPI)?
How is it calculated? What’s it used for?
• What are the problems with the CPI? How
serious are they?
• How does the CPI differ from the GDP deflator?
• How can we use the CPI to compare dollar
amounts from different years? Why would we
want to do this, anyway?
• How can we correct interest rates for inflation?

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 4
management system for classroom use.
 The Consumer Price Index
• Consumer price index (CPI)
– Measure of the overall level of prices
– Measure of the overall cost of goods and
services
– Bought by a typical consumer
– Computed and reported every month by
the Bureau of Labor Statistics

5
 Domestic Expenditure

(C+I+G)
GDP

X M
 GDP Deflator
n

GDP Nominal t 

i 1
Pi t  Qit 
Pt   100  n
 100
GDP Real t 
 Pi 0  Qit 
i 1

P t  Pt 1
Inflation ratet   t   100
Pt 1
Trường Đại Học Bách Khoa Tp.HCM Kinh tế học đại cương
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© Apr-21 7
 n

 p
i 1
t
i  q i0 
Inflation ratet   t 
CPI t CPI t 1
 100
CPI t  n
 100 CPI t 1
 p
i 1
0
i  q i0 
n n

 p
i 1
t
i q 0
i   p
i 1
t -1
i  q i0 
n  n
 n t 
 p
i 1
0
i  q i0   p
i 1
0
i  q i0  
  pi  q i 
0

t  n
 100   in1  1  100
 p
i 1
t -1
i  q i0  
 
i 1
p t -1
i  q 
0
i


n

 p
i 1
0
i  q i0 
Trường Đại Học Bách Khoa Tp.HCM Kinh tế học đại cương
Khoa Quản lý công nghiệp Chương 07: Lạm phát và Thất nghiệp
© Apr-21 8
 Use the information in the
table above to calculate the
consumer price index for 2016
using 2015 as the base year.
A. 137.5
B. 150
C. 162.5
D. 183.3
 GDP Deflator
n

GDP Nominal t 

i 1
Pi t  Qit 
Pt   100  n
 100
GDP Real t 
 Pi 0  Qit 
i 1

P t  Pt 1
Inflation ratet   t   100
Pt 1
 Use the information in the
table above to calculate the
consumer price index for 2016
using 2015 as the base year.
A. 137.5
B. 150
C. 162.5
D. 183.3
 The fixed basket of goods contains 200
cans of soda and 100 pizzas. The base
year is 2014, and the prices for soda and
pizza are given below. Refer to the table
above. The values for the CPI in 2015
and 2016 are, respectively:

A. 85, 105
B. 108.1, 91.95
C. 100, 100
D. 92.5, 108.75
 The fixed basket of goods contains 200
cans of soda and 100 pizzas. The base
year is 2014, and the prices for soda and
pizza are given below. Refer to the table
above. What is the inflation rate for
2016?

A. 7.5%
B. 8.75%
C. 16.25%
D. 17.6%
 Calculating CPI
1. Fix the basket
– The Bureau of Labor Statistics (BLS) surveys
consumers to determine what’s in the typical
consumer’s “shopping basket.”
2. Find the prices
– The BLS collects data on the prices of all the
goods in the basket.
3. Compute the basket’s cost
– Use the prices to compute the total cost of the
basket
14
 Calculating CPI
4. Chose a base year and compute the CPI
– Cost of basket of goods and services in
current year divided by cost of basket in
base year
– Times 100
5. Compute the inflation rate
– The percentage change in the CPI from the
preceding period
CPI this year−CPI last year
Inflation rate = × 100
CPI last year
15
 Problems with the CPI
• Unmeasured Quality Change
– Improvements in the quality of goods in
the basket increase the value of each
dollar.
– The BLS tries to account for quality
changes but probably misses some, as
quality is hard to measure.
– Thus, the CPI overstates increases in the
cost of living.

25
 The CPI overstates the increase in the
cost of living because:
A. it doesn't take into account
that consumers substitute
toward goods that become
relatively cheaper.
B. it doesn't take into account
the introduction of new
goods that allow consumers
access to a greater variety of
goods .
C. it doesn't take into account
improvements in the quality
of goods in the market
basket.
D. all of the above are correct.
 To what extent do you agree with the following statement?
Social Security payments should be adjusted by a bit less than
the inflation rate computed from the Consumer Price Index.

A. strongly agree
B. agree
C. disagree
D. strongly disagree
Two Measures of Inflation, 1965–2016

GDP deflator
Percent change per year

CPI

29
 Demand-pull inflation

Price AD1 AD2 AS

level

P1

P0 E0

Y0 Y1 Output
 Cost-push inflation

Price AD AS2
level

AS1

P1

P0
E0

Q1 Q0 Output
 Determinants of Inflation: Money growth
(The Quantity Theory)
• The quantity equation: M x V = P x Y
1. V is stable.
2. A change in M causes nominal GDP (P x Y)
to change by the same percentage.
3. A change in M does not affect Y: money is
neutral, Y is determined by technology &
resources
4. So, P changes by same percentage as
P x Y and M.
5. Rapid money supply growth causes rapid
inflation.
22
 Problems with the CPI
• Substitution Bias
– Over time, some prices rise faster than
others
– Consumers substitute toward goods that
become relatively cheaper, mitigating the
effects of price increases.
– The CPI misses this substitution because it
uses a fixed basket of goods.
– Thus, the CPI overstates increases in the
cost of living.
23
 Contrasting the
CPI and GDP Deflator
• Imported consumer goods:
– Included in CPI
– Excluded from GDP deflator
• Capital goods:
– Excluded from CPI
– Included in GDP deflator (if produced
domestically)

33
 Contrasting the
CPI and GDP Deflator
• The basket:
– CPI uses fixed basket
– GDP deflator uses basket of currently
produced goods & services
– This matters if different prices are
changing by different amounts.

34
 Active Learning 3 CPI vs. GDP deflator
In each scenario, determine the effects on the
CPI and the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
C. Armani raises the price of the Italian jeans it
sells in the U.S.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 35
management system for classroom use.
 Active Learning 3 Answers
A. Starbucks raises the price of Frappuccinos.
The CPI and GDP deflator both rise.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
The GDP deflator rises, the CPI does not.
C. Armani raises the price of the Italian jeans it
sells in the U.S.
The CPI rises, the GDP deflator does not.

36
 Correcting Variables for Inflation
• Comparing dollar figures from different times
– Inflation makes it harder to compare dollar
amounts from different times.
• Example: the minimum wage
• $1.25 in Dec 1963
• $7.25 in Dec 2013
– Did min wage have more purchasing power
in Dec 1963 or Dec 2013?
– To compare, use CPI to convert 1963 figure
into “2013 dollars”…
40
 Correcting Variables for Inflation
• Dollar figures from different times
Amount in today′s dollars =
Price level today
= Amount in year T dollars ×
Price level in year T
• In our example:
– “year T ” is 1963, “today” is 2013
– Min wage was $1.25 in year T
– CPI = 30.9 in year T, CPI = 234.6 today
– The minimum wage in 1963 was”
$1.25 x 234.6/30.9 = $9.49 in 2013 dollars.

41
 Other things constant, if Dunkin Doughnuts
increases the price of coffee, then both the CPI
and GDP deflator increase.
A. True
B. False
 Other prices the same, an increase in the
price of French wine would increase
A. both the GDP
deflator and the CPI.
B. the GDP deflator
but not the CPI.
C. the CPI but not the
GDP deflator.
D. neither the GDP
deflator nor the CPI.
The group of goods and services used
to compute the GDP deflator changes
automatically over time.
A. True
B. False
 Correcting Variables for Inflation
• Indexation
– A dollar amount is indexed for inflation
if it is automatically corrected for inflation
by law or in a contract.
• The increase in CPI automatically determines:
– The COLA in many multi-year labor
contracts.
– Adjustments in Social Security payments
and federal income tax brackets.

45
 Correcting Variables for Inflation
Real vs. Nominal Interest Rates
• The nominal interest rate:
– Interest rate not corrected for inflation
– Rate of growth in the dollar value of a deposit or
debt
• The real interest rate:
– Corrected for inflation
– Rate of growth in the purchasing power of a
deposit or debt
Real interest rate=(nominal interest rate)–(inflation rate)
46
Suppose you buy a house in 2016 and finance it with a 30-year
mortgage that has a 6 percent annual rate of interest. Inflation
during 2017 is 4 percent. What is the real rate of interest you
pay on your mortgage in 2017?
A. 6 percent + 4
percent
B. 6 percent – 4
percent
C. 6 percent/4percent
D. 6 percent – 6
percent x 4 percent
 A friend tells you that he deposited money in a bank one year
ago and it now purchases 2% more goods than it did a year ago.
Which of the following is consistent with this claim?
A. the nominal interest
rate was 1% and the
inflation rate was 1%
B. the nominal interest
rate was 3% and the
inflation rate was 5%
C. the nominal interest
rate was 6% and the
inflation rate was 4%
D. the nominal interest
rate was 7% and the
inflation rate was 3.5%
 Real vs. Nominal Interest Rates
Example:
– Deposit $1,000 for one year.
– Nominal interest rate is 9%.
– During that year, inflation is 3.5%.
– Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
– The purchasing power of the $1000 deposit
has grown 5.5%.

49
 Real and Nominal Interest Rates in the U.S.,
1960–2015
Interest rate (percent per year)

Real
Nominal

50
In 1991 a median home cost $122,000 and CPI =
137. In 2016, the median home cost $219,400
and CPI = 237.7. In real terms
A. Houses were more
expensive in 1991.
B. Houses were more
expensive in 2016.
C. Houses were the
same in both years.
D. Not enough
information to
answer.
 Correcting Variables for Inflation
• Comparing dollar figures from different times
– Inflation makes it harder to compare dollar
amounts from different times.
• Example: the minimum wage
• $1.25 in Dec 1963
• $7.25 in Dec 2013
– Did min wage have more purchasing power
in Dec 1963 or Dec 2013?
– To compare, use CPI to convert 1963 figure
into “2013 dollars”…
40
 Correcting Variables for Inflation
• Dollar figures from different times
Amount in today′s dollars =
Price level today
= Amount in year T dollars ×
Price level in year T
• In our example:
– “year T ” is 1963, “today” is 2013
– Min wage was $1.25 in year T
– CPI = 30.9 in year T, CPI = 234.6 today
– The minimum wage in 1963 was”
$1.25 x 234.6/30.9 = $9.49 in 2013 dollars.

41
 Correcting Variables for Inflation
• Comparing dollar figures from different
times
– Researchers, business analysts, and
policymakers often use this technique to
convert a time series of current-dollar
(nominal) figures into constant-dollar (real)
figures.
– They can then see how a variable has
changed over time after correcting for inflation.
– Example: the minimum wage…
42
 The U.S. Minimum Wage in Current Dollars
and Today’s Dollars, 1960–2013

2013 dollars

current dollars

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 43
management system for classroom use.
Active Learning 4 Comparing tuition increases
Tuition and Fees at U.S. Colleges and Universities
1990 2015
Private non-profit 4-year $9,340 $32,405

Public 4-year $1,908 $9,410

Public 2-year $906 $3,435

CPI 130.7 237.7
• Express the 1990 tuition figures in 2015 dollars,
then compute the percentage increase in real terms
for all three types of schools.
• Which type experienced the largest increase in real
tuition costs?
44
 Correcting Variables for Inflation
• Indexation
– A dollar amount is indexed for inflation
if it is automatically corrected for inflation
by law or in a contract.
• The increase in CPI automatically determines:
– The COLA in many multi-year labor
contracts.
– Adjustments in Social Security payments
and federal income tax brackets.

45
 Correcting Variables for Inflation
Real vs. Nominal Interest Rates
• The nominal interest rate:
– Interest rate not corrected for inflation
– Rate of growth in the dollar value of a deposit or
debt
• The real interest rate:
– Corrected for inflation
– Rate of growth in the purchasing power of a
deposit or debt
Real interest rate=(nominal interest rate)–(inflation rate)
46
Suppose you buy a house in 2016 and finance it with a 30-year
mortgage that has a 6 percent annual rate of interest. Inflation
during 2017 is 4 percent. What is the real rate of interest you
pay on your mortgage in 2017?
A. 6 percent + 4
percent
B. 6 percent – 4
percent
C. 6 percent/4percent
D. 6 percent – 6
percent x 4 percent
 A friend tells you that he deposited money in a bank one year
ago and it now purchases 2% more goods than it did a year ago.
Which of the following is consistent with this claim?
A. the nominal interest
rate was 1% and the
inflation rate was 1%
B. the nominal interest
rate was 3% and the
inflation rate was 5%
C. the nominal interest
rate was 6% and the
inflation rate was 4%
D. the nominal interest
rate was 7% and the
inflation rate was 3.5%
 Real vs. Nominal Interest Rates
Example:
– Deposit $1,000 for one year.
– Nominal interest rate is 9%.
– During that year, inflation is 3.5%.
– Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
– The purchasing power of the $1000 deposit
has grown 5.5%.

49
 Real and Nominal Interest Rates in the U.S.,
1960–2015
Interest rate (percent per year)

Real
Nominal

50
 Personal Income Tax in Vietnam 2020:
Exemptions and Reductions
• Tax-exempt incomes: Vietnam’s tax authorities have
singled out a number of incomes that are exempt
from PIT:
– Income from transfer of residential houses by
individuals who possess only one residential house or
land plot;
– Interest earned on deposit from the bank or from life
insurance contracts;
– Overseas remittance, retirement pension, scholarship;
– Income from compensation for insurance contracts or
from charity funds;
– Wages paid for night shift or overtime work, which are
higher than those paid for day shifts or prescribed
working hours in accordance with the law; and
– Income received from governmental or non-
governmental foreign aid for charity or humanitarian
purposes approved by competent state agencies.
51
 Personal Income Tax in Vietnam 2020:
Exemptions and Reductions
• Tax deduction: A resident taxpayer is allowed to deduct
from his taxable income US$388 (VND9,000,000) every
month or US$4,700 (VND108,000,000) every year. The
yearly amount can be fully deducted, regardless of whether
the taxpayer had an income every month.
• Tax reductions for dependents: The tax reduction for
each dependent is pegged at US$155 (VND 3,600,000) per
month. Qualified dependents are children aged below 18
years old, or children over 18 years old but earning a
low income, which does not exceed US$21 (VND 500,000)
per month. In addition, spouses or parents of taxpayers
who are unable to work or have low income are also
qualified dependents.
52
 Vietnam considers new PIT threshold 2020

• The document proposed a new PIT threshold of VND11 million

(US$472) a month, which is VND2 million ($86) higher than the
current level, for taxpayers, and VND4.4 million ($189),
compared to the effective threshold of VND3.6 million ($154), for
dependents.
• The increase of the news thresholds is calculated based on the
23.2 % growth of the consumer price index (CPI) between July 1,
2013, when the revised Law on Personal Income Tax came into
effect, and the end of December 2019.
• The Ministry of Finance estimates that the yearly state budget
revenue will fall by VND10.3 trillion ($441.6 million) once the draft
resolution is passed as taxpayers enjoy reduced payable tax.

53
 Summary
• The Consumer Price Index is a measure of the
cost of living. The CPI tracks the cost of the
typical consumer’s “basket” of goods & services.
• The CPI is used to make Cost of Living
Adjustments and to correct economic variables
for the effects of inflation.
• The real interest rate is corrected for inflation
and is computed by subtracting the inflation rate
from the nominal interest rate.

54
A small nation of ten people idolizes the TV show The Voice. All
they produce and consume are karaoke machines and CDs, in
the following amounts:

a) Using a method similar to the CPI, compute the percentage

change in the overall price level. Use 2017 as the base year
and fix the basket at 1 karaoke machine and 3 CDs.
b) Using a method similar to the GDP deflator, compute the
percentage change in the overall price level. Also use 2017 as
the base year.
c) Is the inflation rate in 2018 the same using the two methods?
Explain why or why not