Lecture 2

MEASURING
THE COST OF LIVING

1
 Contents
Problems in Measuring the Cost of Living

The GDP deflator versus the CPI

Correcting economic variables for the effects of

inflation

2
Problems in Measuring the Cost of Living

 Substitution Bias

 Introduction of new good

 Unmeasured changes in quality

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 The GDP deflator versus the CPI
The difference between Nominal GDP and Real GDP
APPLE Nominal GDP of year 2 Real GDP of year 2
GDP 1 = $1000 + 20% GDP 2 = $1200 Q 2 = 2182

P 2 = $0.55
X =$ 1091
P 1 = $0.50 P1 = $0.50
GDP 2 with P 2 GDP 2 with P 1
$91 of real grow
$ 200
Q2 Q2
Q1 Q1

GDP 1 GDP 1

P1 P2 P1
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 The GDP deflator versus the CPI
o For Nominal GDP at the same year, it is bigger than the
real GDP of that year, but it doesn’t mean that the country
produces more. The inflation drives the nominal GDP.

o By calculating the real GDP, we can tell if we do produce

more goods and services.

How can we figure out the relationship

between Nominal GDP and real GDP?

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 Nominal GDP
GDP Deflator = Real GDP
X 100 %

• Exercise:

If Nominal GDP is $100B and real GDP is • Nominal GDP – Not adjusted for inflation
$80B. What is the GDP Deflator? • Real GDP – Adjusted for inflation

Answer
100B
GDP Deflator = X 100 % = 125 Price increase 5%
80B since the base year

Show how prices have changed

since the base year
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 The GDP deflator versus the CPI

GDP deflator CPI

Reflects the prices of Reflects the prices of

all goods and services all goods and services
produced bought by consumers.
domestically.

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The GDP deflator versus the CPI

Suppose that Lamborghini raises

the price of its cars.

Lamborghinis are made in Germany

Þ The car is not the part of US’s GDP.

US consumers buy Lamborghinis

=> The car is the part of the typical
consumer’s basket of goods.

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 The GDP deflator versus the CPI

Suppose that the price of an

airplane produced by Boeing and
sold to the Air Force rises.

The price increase shows up in the

GDP deflator but not in the
consumer price index

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 The GDP deflator versus the CPI

GDP deflator CPI

Compares the price of Compares the price of

currently produced a fixed basket of
goods and services to goods and services to
the price of the same the price of the basket
goods and services in in the base year.
the base year.

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11
Correcting economic variables for the
effects of inflation

 Dollar figures from different times

 Real and nominal interest rate

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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

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Dollar figures from different times

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 Real and nominal interest rate

• Norminal Interest Rate does not take inflation into

account

• Real Interest Rate takes inflation into account

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 Real and nominal interest rate

• Norminal Interest Rate does not take inflation into

account

• Real Interest Rate takes inflation into account

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 Real and nominal interest rate

• You borrowed $1000 for 1 year

• Nominal interest rate was 15%
• The year inflation was 10%

Real interest rate

= Nominal interest rate – Inflation
= 15% - 10%
= 5%

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 Summary
• The consumer price index (CPI) shows the cost of a
basket of goods and services based on the cost of the
same basket in the base year.

 CPI is used to measured the overall level of prices in

the economy

 The percentage change in the CPI measure the

inflation rate.
 Summary

CPI is an imperfect measure of

the cost of living

The Unmeasured
Substitution
introduction changes in
bias
of new goods quality
• Because of the measurement problems, the CPI overstates
the annual inflation by about 1 % point.
 Summary
• Difference between GDP deflator and CPI

GDP Deflator CPI

Includes goods and Includes goods and

services produced services consumed

Automatically changes Use fix basket of goods

the group of goods and
services overtime as the
composition of GDP
changes
 Summary
• Dollars figures from different points in time
do not represent a valid comparison of
purchasing power.

• The real interest rate = nominal interest rate

– the rate of inflation