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Lecture 4 The GDP price deflator and CPI, Nominal and Real Interest Rates and a Common Structure

to study, growth, inflation and interest rates The GDP price deflator and inflation As we saw last time, nominal variables suffer from price illusion: when current prices are employed, we obtain inflated measures of economic activity. Because we are primarily interested in assessing real economic activity, we will use price indexes to deflate nominal variables. When a nominal variable is divided by a price index, price illusion will be eliminated. In general, price indexes give a measure of the average price level of a group of goods and services relative to a base year. The GDP price deflator is the price index that is used to deflate nominal GDP into real GDP. GDPnom GDPnom deflator = Because GDPRe al = * 100 1 GDPRe al deflator 100 Lets label a nonspecific price index with P. Inflation is the growth rate in the price index: P P0 P 1. = 1 or = 1 P0 P0 By manipulating expression 1. as we did with the GDP growth rates last time, we obtain two alternative (and equivalent) expressions linking P to inflation: P 2. (1 + ) = 1 and 3. P1 = P0 (1 + ) P0 Expression 2. states that the ratio between the price indexes in the two periods is equal to 1 plus the inflation rate and expression 3. derives the price index in the second period as the price index in the other period multiplied by (1+). Lets look at example we used above: GDP Nom 04 * 100 = 100 , where the first number in the subscript indicates deflator04,04 = GDP Re al 04,04 the year and the second number stands for the base year. Notice that, in the base year, the GDP price deflator is always equal to 100.
230,000 GDP Nom 05 * 100 = * 100 = 109.5 deflator05, 04 = Re al 210,000 GDP 05, 04 Therefore, if we use the GDP deflator as a price index, deflator1 9.5 = = .095 or 9.5% deflator0 100
Dont worry if you did not multiply the ratio by 100: the percentage change in the deflator will not be affected. Make sure you understand why.

As an exercise, you may compute the GDP deflators of the two years by setting 2005 as the base year. You will notice that the measure of inflation is sensitive to the choice of the base year: your inflation estimate will be different than 9.5%. As with real GDP, this contradicting evidence has been solved by the use of chain-weighted real GDP. There are also other alternative price indexes that we can use to compute different measures of inflation. The disparity between the alternative price indexes lies on the different goods (and services) they are based on and whether or not the importance assigned to each good (what we call weight) changes over time. The Consumer Price Index (CPI) The CPI is an alternative price index given by the ratio between the amount of money that the average consumer would pay for a fixed basket of goods and services during a period of time, say the current year, relatively to another year, called the base year.2 $ amount for fixed basket at time t CPI t = *100 $ amount for fixed basket in base year Example: Suppose that the basket is composed of 15 books and 100 units of hamburgers. The table below illustrates the price of one book and one burger is 2000 and 2005. Also, assume that 2000 is the base year. Goods in the Basket Price per Unit 100 Burgers 2 2000 15 Books 20 100 Burgers 2.2 2005 15 Books 100

The $ amount to purchase the basket in 2000 is $(2*100+20*15) =$500 The $ amount to purchase the basket in 2005 is $(2.2*100+100*15) =$1720

1720 500 *100 = 344 . CPI 2000 = * 100 = 100 500 500 Note that the CPI in the base year is equal to 100
Therefore, CPI 2005 =

The inflation rate between 2000 and 2005 is: P P0 CPI 2005 CPI 2000 244 = = = 2.44 or 244% 1. = 1 P0 CPI 2000 100

Usually, this ratio is multiplied by 100. However, forgetting the 100 will not cause any change in the inflation measure. Right?

The CPI in the US3 Of course, in the real world, the CPI is not composed of 2 goods only. In the US, the Bureau of Labor Statistics ( is the agency in charge of computing the CPI. The BLS provides CPI estimates at a monthly frequency. There are approximately 80,000 goods and services comprising the basket of the representative consumer. The CPI is based on the spending patterns of urban citizens, since they represent 87% of the population. Its important to understand that the CPI is based on what the average urban consumer is expected to purchase. Of course, each of us is affected by changes in prices in different ways because each of us chooses different consumption baskets. Keep this in mind if you want to evaluate the effects of price changes on different strata of the population.4 The great advantage of the BLS data is that they are also disaggregated by category of goods and services, so that constructing a personalized index is not difficult. In addition, the BLS also provides disaggregated data according to the consumers geographical location: there is a CPI for New York and the Tri-State Area, one for San Francisco and The Bay Area and so on. The base year in the US is the average price of the basket for the period 1982-1984. The basket mix is updated once in a while in order to adjust the basket for new goods and services and to adjust to new consumption profiles. De facto, the adjustment of the basket happens only rarely by collecting expenditure data through very costly surveys. The basket that is used right now is based on the consumption decisions of 2003-2004, called the Reference Expenditure Period. One of the limitations of the CPI is the rigidity of the quantities in the basket.5 The BLS wants to reduce this shortcoming by updating the basket more often. Differences between the CPI and the GDP Price Deflator

1. While the CPI is computed by looking at the price of only those goods and services that consumers purchase, the GDP price deflator is based on the price of all goods and services produced in a nation. Therefore, there are some goods and services in the GDP deflator that are excluded from the CPI (government purchases and investment expenditures).
2. This is a corollary of point 1. While the CPI includes imported goods and services, the GDP price deflator excludes imports.

3. While the CPI is a fixed-weight index, the GDP price deflator updates the weights according to the quantities produced. The regular adjustment of the weights is an advantage of the GDP price deflator. However, there are some
A related measure is CORE CPI: the new basket excludes spending on energy and food-related components that are historically the most volatile components. Therefore, core CPI appears to be more stable than the CPI measure. 4 How different are you compared to the average US urban consumer? What are your weights? 5 Also, consumers do change their consumption profile when prices vary: they consume greater quantities of what has become relatively cheaper and smaller quantities of what has become relatively more expensive. Well cover this issue in the study of consumer theory after the midterm.

pathological examples for which the adjustment in the weights is problematic. For instance, consider a small country that is hit by a hurricane. This leads to the destruction of the harvest: say, the production of wheat goes to zero. Because of the scarcity of wheat, wheat prices increase and all wheat consumed is imported from abroad at a higher price. Under these circumstances, the GDP price deflator would not include the increase in the price of wheat because the production of wheat is zero (the weight to wheat goes to zero). On the other hand, the CPI would significantly increase.
Interest rates The nominal interest rate, i, is the rate of return from an asset. The rate of return of an asset is given by the percentage difference between its final value, V1 and its current value, V0: V V0 1. i = 1 V0 V We can then rearrange expression 1. to get: 2. 1 + i = 1 and 3. V1 = V0 (1 + i ) V0 The ratio between future and current value of the asset is equal to 1 plus the nominal interest rate and the future value of the asset is equal to the current value multiplied times (1 + i). Different assets offer different returns because they are characterized by different attributes. At this point in the course, however, we will assume that all assets offer the same rate of return.6 This is a strong assumption that is not supported by the evidence. However, asset returns do tend to move together. Thats why in macroeconomics you will often hear people talking about the interest assuming that all assets are merged together.

If we compute the interest rate as in expression 1, the measure we will obtain is a nominal amount, as it is appraised in units of money. The decision to hold assets, however, is not linked to monetary returns. People purchase assets because they are interested in real returns: returns in terms of goods and services they can purchase. For example, suppose that V0 = $100 and V1 = $110 and we are looking at an economy where the only goods consumed are cans of Coke. The nominal return of a person purchasing an asset in the present is 10%. The real return is the return in terms of cans of Coke. Suppose that one can of Coke costs $.50 in the present and will cost $.55 in the future. If a person purchased an asset in the present, she does not care about giving up $100; she cares about giving up 100/.50 = 200 cans of Coke. In the next period, she will get $110 but she will be able to purchase 110/.55 = 200 cans of Coke. Therefore, her real return, her return in terms of cans of Coke is equal to zero. Following this intuition:

Next semester you will study, in detail, how country risk, currency risk, liquidity, and maturity affect asset returns.

V1 V1 P V (1 + i ) 1+ r = 1 1+ r = 0 1+ r = P1 (1 + ) V0 P P0 0

When interest rates and inflation are small enough, we can approximate the real interest rate as r i

When we compute the real interest using the actual inflation rate, we are evaluating what is called the ex post real interest rate.7 When people purchase an asset, however, they are only aware of the nominal return. They cannot predict with certainty what inflation will be.8 When we compute the real interest rate using expected inflation rather than actual inflation, we are evaluating what is called the ex-ante real interest rate.9

7 8

Ex-post comes from Latin and stands for after In many assets, it is also very possible that the nominal return is not known with certainty. For now we exclude such possibility. 9 Ex-ante comes from Latin and stands for before.

A Common framework to compute growth rates, inflation rates and interest rates Growth rate: It is nice to have one single structure that works GDP1 GDP0 GDP1 for all! You need to study one case only and then g= or g= apply it to the other two. You just have to change GDP0 GDP0 V, GDP or P according to the question asked. GDP1 1+ g = GDP1 = GDP0 (1 + g ) GDP0 Inflation:

P1 P0 P0 P1 P0


P1 P0

1+ =

P1 = P0 (1 + g )

Nominal Interest Rate (or risk-free return):

V1 = V0 (1 + i ) i=


1+ i =

V1 V0

V V0 V1 i= 1 V0 V0 Examples and Compounding (annualizing)

1. These are data on quarterly real GDP in 2006. What was GDP over 2006? Q1 2006 Q2 2006 Q3 2006 Q4 2006 Annual

Annual = (Q1+Q2+Q3+Q4)/4



11,395.5 ?


Quarterly GDP is multiplied by 4 in order to make it comparable with annual GDP. However, this may induce people to think that GDP is a stock variable.

2. What is the GDP growth rate between the second and the first quarter of 2007? CHANGE Real GDP in the US: Q2/07 = 11,523.8 Q1/07 = 11,412.6

Quarterly growth rate: (GDP2,07-GDP1,07)/GDP1,07= 0.009744 or approximately.97% This .97% is difficult to grasp. Hence, growth rates are usually always presented as annualized variables. We assume that the same growth rate continues for four consecutive quarters. What was the annualized growth rate? Notice the multiplicative structure of growth rates: GDP2,07= GDP1,07(1+g) GDP3= GDP2(1+g) => GDP3= GDP1(1+g)2
=> GDP1,07= GDP1,06(1+g)4 =>

GDP1, 07 GDP1, 06

= (1 + g ) 4

1 + g annualized = (1 + g1 quarter ) 1 + g annualized

GDPQ 2,07 = GDP Q1, 07


GDPQ 2, 07 g annualized = GDP Q1, 07 4 = (1.009744) 1 g annualized 3.95%

4 1 = 11,523.8 1 11,412.6

3. Suppose that a country only cares about the value of real GDP in two years from this year. One option is that the country has a 10% growth rate from year 0 to year 1 and a 20% growth rate from year 1 to year 2. The second option is to have a 20% growth rate from year 0 to year 1 and a 10% growth rate between year 1 and year 2. Which is the best option?

GDP1= GDP0(1+g1) GDP2= GDP1(1+g2) => GDP2= GDP0(1+g1) (1+g2)

4. Suppose that a country grows at 10% for the first year and at 20% the second year. What was the (average) annual growth rate? 15%?

(1 + .1)(1 + .2) = (1 + x) 2 1.32 = 1 + x x = 1.1489 1 x = 14.89%

1/ 2

The average growth rate (or annualized growth rate) is not the arithmetic average. Growth rates are multiplied (compounded), not added. For the same reason, you cannot add growth rates. The average growth rate is the geometric average.

5. Real GDP in 1929 was 865.2 billion and real GDP in 2004 was 10755.7. What was the average annual GDP growth rate?

GDP2004 (1 + g annual ) 75 = GDP 1929 g annual g annual

1 / 75

GDP2004 10775.7 = 1 = GDP 865.2 1929 = (12.4314)1 / 75 1 3.41%

1 / 75

6. The CPI index was 203.2 on July 2005 and it was equal to 202.3 in June 2005. What was the annualized inflation rate? 12 1 + annaulized = (1 + 1 month )

1 + annaulized annualized annualized

PJuly = P June


203.2 12 = 1 = 1.004449 1 202.3 5.47


7. Lets compute the average inflation rate of the numerical example we saw at page 2: 5-year inflation rate = 244%. What was the annualized inflation rate?
CPI 2005 (1 + annual ) 5 = CPI 2000
1/ 5

annual = (3.44 )

annual = 1.28 1 28%