Please only answer #2 and #4.

Ch. 24 Cost of Living

(ex)

Say, you got two job offers with annual salaries as follows:

Chicago job: $60,000

New York job: $70,000

Which one are you going to choose?

If you want to choose depending on the real value, how can you measure?

Discussions in the chapter will answer those questions.

In the question above, you will consider levels of prices in two cities.

If price levels are:

Chicago: 110

New York: 130, then we can figure out which offer is more valuable.

Definitions:

Nominal GDP (Y) = GDP measured in current dollar value.

Real GDP (y) = GDP measured in index year (base year) dollar value.

Current year's (or base year's) dollar value? Does dollar value change? Yes, as time passes, money value changes because of changing prices. About 20 years ago, the price of a book of principles of macroeconomics was about $30. Now you pay about $200 or more for the same book. Price increased. This higher price on the other hand means that value of money declined. Thus, monetary value of a product is different in a different year.

Nominal vs. Real GDP:

Let's consider a small economy that produces foods and machines only.

The economy produced products as the follows.

Year 0

Quantity (Q₀) Price (P₀) total market value

Foods 10,000 $10 $100,000

Machines 20 $20,000 $400,000

Nominal GDP (sum of market values of foods and machines): $500,000

Year 1

Quantity (Q₁) Price (P₁) total market value

Foods 10,000 $12 $120,000

Machines 25 $20,000 $500,000

Nominal GDP (sum of market values of foods and machines): $620,000

Notice that nominal GDP is sum of values of products that are measured by each year's price level. Also notice that nominal GDP can increase because of higher prices. That is, the market value of 10,000 foods in year 1 is higher than that of year 0 because the unit price went up from $10 to $12. The nominal GDP can also increase because of higher level of production (See the level of production of machines).

If we use year 0 as the base year, we can calculate year 1's real GDP. Real GDP is sum of values of products that are measured with base year's prices.

Year 1

Quantity (Q₁) Price (P₀) total market value

Foods 10,000 $10 $100,000

Machines 25 $20,000 $500,000

Real GDP (sum of market values of corns and machines): $600,000

**Note that P₀ is year 0's price and used as the base year price. The $600,000 is the real GDP of year 1 because it is calculated with base year's price, P₀.

In the real world, economies produce numerous numbers of products, so, to figure out the real GDP, we use price indexes instead of each individual prices of each year. Price indexes show the general levels of price of each year. Using these indexes we can compare price levels across years. And also, using the indexes we can compute the real GDP of each year.

Price Indexes:

Price indexes are designed to reflect price changes of consumer's goods and services, producers' prices, whole sale prices, and developed for many other purposes. Price indexes are basically percentage numbers to compare the magnitude of a year's price level against index year's price level (index year's price level is always 100). Sometimes we use decimal numbers for indexes (always 1 for the base year). The Bureau of Labor Statistics (BLS) computes those indexes and many other macro economic indicators.

CPI (Consumers Price Index):

CPI measures relative level of price of each year using a year (or moving average of 3 years) as a base year. Includes prices of items of consumer's goods and services that normally middle class urban residents buy (this is to consider items that are important for major group of people). As time passes, economy changes, so some items become less important, some items become useless, and some new items appear as important products for everyone's daily life. BLS drops those that became useless from the basket of items, and picks those newly appearing items for calculating the index numbers. These are efforts to figure out accurate index numbers that show the cost of living. For instance, internet service price was not very important 20 years ago, but this should be in the basket as it became an important item for average citizens.

GDP deflator: Ratio of nominal GDP to real GDP.

Includes items that are included in GDP calculation.

WPI (Wholesale Price Index): shows changes in whole sale prices.

PPI (Producer Price Index): shows changes of producer's price.

This directly shows changes in production cost. If this goes up, we expect

WPI and CPI will increase soon.

When nominal GDP is divided by the year's price index (CPI, or GDP deflator), we get that year's real GDP.

Nominal GDP / CPI (decimal number) = real GDP

Nominal GDP (Y) = CPI (decimal number)*real GDP

*GDP deflator can be used instead of CPI.

(ex) GDP of an economy:

Year Nominal GDP ($ billion) GDP deflator GDP deflator

(2010 is used as base year) (2014 is base)

2014 11,685 109.46 100

2015 12,433 113.00 103.2

2016 13,194 116.57 106.5

1. By what % did the price increase between

year 2014 and year 2015? (using 2010 is base year)

(113.00 - 109.46)/109.46 = 0.03234 = 3.234%

This is the inflation rate for a year between 2014 and 2015.

Inflation rate can be calculated using CPI too.

2. By what % did the price increase between

year 2015 and year 2016? (please calculate)

3. What is year 2016's GDP in year 2014's dollars?

First, using the given table, construct new price index in which 2014 is the

index year (base year). How? By definition, index year's price is 100. So to find other years' new indexes, divide the given index numbers by original index year's price. For 2015, 113.00/109.46 = 1.032 = 103.2% (remember that price indexes are percentage numbers). For 2016, 116.57/109.46 = 1.065 = 106.5%.

Thus, the price level of 2016 is 1.065 or 106.5%.

Apply that real GDP = nominal GDP/price index

So, the real GDP of 2016 measured by 2014's dollar is $13,194billion/1.065

= $12,388billion.

4. By what % did real GDP grow between year 2014 and year 2016?

To find growth rate of real GDP, two GDPs must be measured in the same

year's dollar value.

This growth rate income, using real GDP, is also called growth rate of economy.

Now, considering sizes of population, we want to calculate per capita GDP.

Per capita GDP = GDP/population

GDP or per capita GDP shows level of income.

GDP, or per capita GDP are important economic indicator showing roughly economic situations, but not enough to tell living standard, or level of social welfare of each country.