Economic Indicators and The Business Cycle

Macroeconomics 2:
Unit: Economic indicators and the

business cycle
Contents:
 Gross Domestic Product

 Limitations of GDP
 Unemployment
 Inflation
 Costs of Inflation
 Real vs. nominal GDP
 Business cycles
About this unit
In this unit, you'll learn to identify and examine key measures of economic performance: gross
domestic product, unemployment, and inflation. The concept of the business cycle also gives you
an overview of economic fluctuations in the short run.
Measuring the size of the economy: gross domestic

product
Key points
 The size of a nation’s economy is commonly expressed as its gross
domestic product, or GDP, which measures the value of the output of all
goods and services produced within the country in a year.
*GDP is measured by taking the quantities of all final goods and services
produced and sold in markets, multiplying them by their current prices, and
adding up the total.
 GDP can be measured either by the sum of what is purchased in the

economy using the expenditures approach or by income earned on what is
produced using the income approach.
 The expenditures approach represents aggregate demand (the demand
for all goods and services in an economy) and can be divided into
consumption, investment, government spending, exports, and imports. What
is produced in the economy can be divided into durable goods, nondurable
goods, services, structures, and inventories.
 To avoid double counting—adding the value of output to the GDP

more than once—GDP counts only final output of goods and services, not the
production of intermediate goods or the value of labor in the chain of
production.
 The gap between exports and imports is called the trade balance. If a

nation's imports exceed its exports, the nation is said to have a trade deficit.
If a nation's exports exceed its imports, it is said to have a trade surplus.
Introduction
To understand macroeconomics, we first have to measure the economy. But
how do we do that? Let's start by taking a look at the economy of the United
States.
The size of a nation’s overall economy is typically measured by its gross

domestic product, or GDP, which is the value of all final goods and services
produced within a country in a given year. Measuring GDP involves counting
up the production of millions of different goods and services—smart phones,
cars, music downloads, computers, steel, bananas, college educations, and all
other new goods and services produced in the current year—and summing
them into a total dollar value.
The numbers are large, but the task is straightforward:

Step 1: Take the quantity of everything produced.
Step 2: Multiply it by the price at which each product sold.
Step 3: Add up the total.
In 2014, the GDP of the United States totaled $17.4 trillion, the largest GDP
in the world.
It's important to remember that each of the market transactions that enter into
GDP must involve both a buyer and a seller. The GDP of an economy can be
measured by the total dollar value of what is purchased in the economy or by
the total dollar value of what is produced.
Understanding how to measure GDP is important for analyzing connections

in the macro economy and for thinking about macroeconomic policy tools.
GDP measured by components of demand

$17.4 trillion is a lot of money! Who buys all of this production? Let's break
it down by dividing demand into four main parts:
 Consumer spending, or consumption

 Business spending, or investment
 Government spending on goods and services
 Spending on net exports
[Hide explanation.]
What is meant by the word investment?

What do economists mean by investment? When talking about GDP,
investment does not refer to the purchase of stocks and bonds or the trading
of financial assets. It refers to the purchase of new capital goods—new
commercial real estate, such as buildings, factories, and stores, as well as
equipment, residential housing construction, and inventories.
Inventories that are produced this year are included in this year’s GDP—even
if they have not yet sold. From the accountant’s perspective, it is as if the
firm invested in its own inventories.
The table below shows how the four above components added up to the GDP
for the United States in 2014. It's also important to think about how much of
the GDP is made up of each of these components. You can analyze the
percentages using either the table or the pie graph below it.
Components of GDP on the demand Percentage of

side in trillions of dollars total
Consumptio
n $11.9 68.4%
Investment $2.9 16.7%
Government $3.2 18.4%
Exports $2.3 13.2%

Imports –$2.9 –16.7%
Total GDP $17.4 100%

Components of US GDP in 2014: from the demand side
Source: http://bea.gov/iTable/index_nipa.cfm
This pie chart shows the percentage of components of US GDP on the
demand side as follows: consumption is 68.4%; investment is 16.7%;
government is 18.4%; exports are 13.2%; and imports are −16.7%.
Image credit: Figure 1 in "Measuring the Size of the Economy: Gross Domestic Product" by
OpenStaxCollege, CC BY 4.0
This image includes two line graphs: Graph A and Graph B. Graph A shows
the demand from consumption, investment, and government from the year
1960 to 2014. In 1960, the graph starts out at 61.0% for consumption. It
remains fairly steady around 60% until 1993, when it is at 65%. By 2014, it is
at 68.5%.
In 1960, the graph starts out at 22.3% for government. It remains steady
around 20%, and by 2014, it is at 18.2%.
In 1960, the graph starts out at 15.9% for investment. It rises gradually to
20.3% in 1978, then generally goes down to 16.4% in 2014.
Graph B shows imports and exports from the year 1960 to 2014. In 1960, the
graph starts out at 4.2% for imports. It rises fairly steadily with only a few
drops, such as from 14.3% in 2000 to 13.1% in 2001. By 2014 it is at 16.5%.
In 1960, the graph starts out at 5.0% for exports. It remains steadily around
5% until 1973, when it jumps to 6.7%. By 2014, the exports line is at 13.4%.
A few patterns are worth noticing here. Consumption expenditure by

households was the largest component of the US GDP 2014. In fact,
consumption accounts for about two-thirds of the GDP in any given year.
This tells us that consumers’ spending decisions are a major driver of the
economy. However, consumer spending is a gentle elephant—when viewed
over time, it doesn't jump around too much.
Investment demand accounts for a far smaller percentage of US GDP than

consumption demand does, typically only about 15 to 18%. Investment can
mean a lot of things, but here, investment expenditure refers to purchases of
physical plants and equipment, primarily by businesses. For example, if
Starbucks builds a new store or Amazon buys robots, these expenditures are
counted under business investment.
Investment demand is very important for the economy because it is where

jobs are created, but it fluctuates more noticeably than consumption. Business
investment is volatile. New technology or a new product can spur business
investment, but then confidence can drop, and business investment can pull
back sharply.
If you've noticed any infrastructure projects—like road construction—in your

community or state, you've seen how important government spending can be
for the economy. Government expenditure accounts for about 20% of the
GDP of the United States, including spending by federal, state, and local
government.
It's important to remember that a significant portion of government budgets

are transfer payments—like unemployment benefits, veteran’s benefits, and
Social Security payments to retirees—that are excluded from GDP because
the government does not receive a new good or service in return or exchange.
The only part of government spending counted in demand is government
purchases of goods or services produced in the economy—for example, a
new fighter jet purchased for the Air Force (federal government spending),
construction of a new highway (state government spending), or building of a
new school (local government spending).
And finally, we must consider exports and imports when thinking about the
demand for domestically produced goods in a global economy. First, we
calculate spending on exports—domestically produced goods that are sold
abroad. Then, we subtract spending on imports—goods produced in other
countries that are purchased by residents of this country.
The net export component of GDP is equal to the dollar value of
exports, \text{X}Xstart text, X, end text, minus the dollar value of
imports \text{M}Mstart text, M, end text. The gap between exports and
imports is called the trade balance. If a country’s exports are larger than its
imports, then a country is said to have a trade surplus. If, however, imports
exceed exports, the country is said to have a trade deficit .
If exports and imports are equal, foreign trade has no effect on total GDP.
However, even if exports and imports are balanced overall, foreign trade
might still have powerful effects on particular industries and workers by
causing nations to shift workers and physical capital investment toward one
industry rather than another.
Based on the four components of demand discussed above—

consumption, \text{C}Cstart text, C, end text, investment, \text{I}Istart text,
I, end text, government, \text{G}Gstart text, G, end text, and trade
balance, \text{T}Tstart text, T, end text —GDP can be measured as follows:
\text{GDP} = \text{C + I + G + (X -
M)}GDP=C + I + G + (X - M)start text, G, D, P, end text, equals, start
text, C, space, plus, space, I, space, plus, space, G, space, plus, space, left
parenthesis, X, space, negative, space, M, right parenthesis, end text
GDP measured by what is produced

Everything that is purchased must be produced first. Instead of trying to think
about every single product produced, let's break out five categories: durable
goods, nondurable goods, services, structures, and change in inventories. You
can see what percentage of the GDP each of these components contributes in
the table and pie chart below.
Before we look at these categories in more detail, take a look at the table
below and notice that total GDP measured according to what is produced is
exactly the same as the GDP we measured by looking at the five components
of demand above.
Since every market transaction must have both a buyer and a seller, GDP
must be the same whether measured by what is demanded or by what is
produced.
Components of GDP on the supply Percentage of

side in trillions of dollars total
Goods
Durable goods $2.9 16.7%
Nondurable
goods $2.3 13.2%
Services $10.8 62.1%
Structures $1.3 7.4%
Change in
inventories $0.1 0.6%
Total GDP $17.4 100%

Components of US GDP on the production side, 2014
Source: http://bea.gov/iTable/index_nipa.cfm
The pie chart shows that services account for almost half of US GDP
measured by what is produced, followed by durable goods, nondurable goods,
structures, and change in inventories.
The graph shows that since 1960, structures have mostly remained around
10% but dipped to 7.7% in 2014. Durable goods have mostly remained
around 20% but dipped in 2014 to 16.8%. The graph also shows that services
have steadily increased from less than 30% in 1960 to over 61.9% in 2014. In
contrast, nondurable goods have steadily decreased from roughly 40% in
1960 to around 13.7% in 2014.
Image
credit:
Figure 4 in "Measuring the Size of the Economy: Gross Domestic Product" by OpenStaxCollege, CC BY 4.0
Let's take a look at the graph above showing the five components of what is
produced, expressed as a percentage of GDP, since 1960. In thinking about
what is produced in the economy, many non-economists immediately focus
on solid, long-lasting goods—like cars and computers. By far the largest part
of GDP, however, is services. Additionally, services have been a growing
share of GDP over time.
You are probably already familiar with some of the leading service
industries, like healthcare, education, legal services, and financial services. It
has been decades since most of the US economy involved making solid
objects. Instead, the most common jobs in the modern US economy involve a
worker looking at pieces of paper or a computer screen; meeting with co-
workers, customers, or suppliers; or making phone calls.
Even if we look only at the goods category, long-lasting durable goods like
cars and refrigerators are about the same share of the economy as short-lived
nondurable goods like food and clothing.
The category of structures includes everything from homes to office

buildings, shopping malls, and factories.
Inventories is a small category that refers to the goods that have been
produced by one business but have not yet been sold to consumers and are
still sitting in warehouses and on shelves. The amount of inventories sitting
on shelves tends to decline if business is better than expected or to rise if
business is worse than expected.
The Problem of Double Counting

GDP is defined as the current value of all final goods and services produced
in a nation in a year. But what are final goods? They are goods at the furthest
stage of production at the end of a year.
Statisticians who calculate GDP must avoid the mistake of double counting—
counting output more than once as it travels through the stages of production.
For example, imagine what would happen if government statisticians first
counted the value of tires produced by a tire manufacturer and then counted
the value of a new truck sold by an automaker that contains those tires. The
value of the tires would have been counted twice because the price of the
truck includes the value of the tires!
To avoid this problem—which would overstate the size of the economy
considerably—government statisticians count just the value of final goods
and services in the chain of production that are sold for consumption,
investment, government, and trade purposes. Intermediate goods, which are
goods that go into the production of other goods, are excluded from GDP
calculations. This means that in the example above, only the value of the
truck would be counted. The value of what businesses provide to other
businesses is captured in the final products at the end of the production chain.
What is counted in GDP What is not included in GDP

Consumption Intermediate goods
Transfer payments and non-market

Business investment activities
Government spending on goods and

services Used goods
Net exports Illegal goods

Counting GDP
Take a look at the table above showing which items get counted toward GDP
and which don't. The sales of used goods are not included because they were
produced in a previous year and are part of that year’s GDP.
The entire underground economy of services paid “under the table” and
illegal sales should be counted—but is not—because it is impossible to track
these sales. In a recent study by Friedrich Schneider of shadow economies,
the underground economy in the United States was estimated to be 6.6% of
GDP, or close to $2 trillion dollars in 2013 alone.
Transfer payments, such as payment by the government to individuals, are
not included, because they do not represent production. Also, production of
some goods—such as home production as when you make your breakfast—is
not counted because these goods are not sold in the marketplace.
[Want to learn more about how GDP is calculated?]
Summary
 The size of a nation’s economy is commonly expressed as its gross
domestic product, or GDP, which measures the value of the output of all
goods and services produced within the country in a year.
 GDP is measured by taking the quantities of all goods and services

produced, multiplying them by their prices, and summing the total.
 GDP can be measured either by the sum of what is purchased in the

economy or by what is produced.
 Demand can be divided into consumption, investment, government,

exports, and imports. What is produced in the economy can be divided into
durable goods, nondurable goods, services, structures, and inventories.
 To avoid double counting—adding the value of output to the GDP

more than once—GDP counts only final output of goods and services, not the
production of intermediate goods or the value of labor in the chain of
production.
 The gap between exports and imports is called the trade balance. If a

nation's imports exceed its exports, the nation is said to have a trade deficit. If
a nation's exports exceed its imports, it is said to have a trade surplus.
Self-check questions
Country A has export sales of $20 billion, government purchases of $1,000
billion, business investment is $50 billion, imports are $40 billion, and
consumption spending is $2,000 billion. What is the dollar value of GDP?
[Hide solution.]
\text{GDP} = \text{C + I + G + (X - M)}GDP=C + I + G + (X - M)start text,

G, D, P, end text, equals, start text, C, space, plus, space, I, space, plus, space,
G, space, plus, space, left parenthesis, X, space, negative, space, M, right
parenthesis, end text\text{GDP} = \$2,000 \text{ billion} + \$50
\text{ billion} + \$1,000 \text{ billion} + (\$20 \text{ billion} - \$40
\text{ billion})GDP=$2,000 billion+$50 billion+$1,000 billion+($20 billion−
$40 billion)start text, G, D, P, end text, equals, dollar sign, 2, comma, 000,
start text, space, b, i, l, l, i, o, n, end text, plus, dollar sign, 50, start text,
space, b, i, l, l, i, o, n, end text, plus, dollar sign, 1, comma, 000, start text,
space, b, i, l, l, i, o, n, end text, plus, left parenthesis, dollar sign, 20, start
text, space, b, i, l, l, i, o, n, end text, minus, dollar sign, 40, start text, space, b,
i, l, l, i, o, n, end text, right parenthesis\text{GDP} = \$3,030
\text{ billion}GDP=$3,030 billionstart text, G, D, P, end text, equals, dollar
sign, 3, comma, 030, start text, space, b, i, l, l, i, o, n, end text
Which of the following are included in GDP, and which are not?
 The cost of hospital stays

 The rise in life expectancy over time
 Child care provided by a licensed day care center
 Child care provided by a grandmother
 The sale of a used car
 The sale of a new car
 The greater variety of cheese available in supermarkets
 The iron that goes into the steel that goes into a refrigerator bought by a
consumer
[Hide solution.]
Hospital stays are part of GDP. Changes in life expectancy are not market
transactions and thus are not part of GDP. Child care that is paid for is part of
GDP. If Grandma gets paid and reports this as income, it is part of GDP,
otherwise it is not. A used car is not produced this year, so it is not part of
GDP. A new car is part of GDP. Variety does not count in GDP, where the
cheese could all be cheddar. The iron is not counted because it is an
intermediate good.
Review questions
 What are the main components of measuring GDP with what is
demanded?
 What are the main components of measuring GDP with what is

produced?
 Would you usually expect GDP as measured by what is demanded to

be greater than GDP measured by what is supplied, or the reverse?
 Why must double counting be avoided when measuring GDP?
Problem
Last year, a small nation with abundant forests cut down $200 worth of trees.
$100 worth of trees were then turned into $150 worth of lumber. $100 worth
of that lumber was used to produce $250 worth of bookshelves. Assuming the
country produces no other outputs, and there are no other inputs used in the
production of trees, lumber, and bookshelves, what is this nation's GDP?
In other words, what is the value of the final goods produced including
trees, lumber and bookshelves?
Lesson summary: The circular flow and GDP
Lesson Overview
Just how much stuff did the nation of Gerbilalia produce last year? We can
use one of our key macroeconomic measures, gross domestic product
(GDP), to figure this out.
GDP can be measured in three different ways: the value added approach,

the income approach (how much is earned as income on resources used to
make stuff), and the expenditures approach (how much is spent on stuff).
However, you will likely run into the expenditures approach the most as you
progress through this course.
A model called the circular flow diagram illustrates how the expenditures

approach and the income approach must equal each other, with goods and
services flowing in one direction and income flowing in the opposite
direction, in a closed loop.
Key Terms
Term Definition
gross the market value of the final production of goods and
domestic services within the geographic borders of a country in a
Term Definition
given period; for example, if the GDP of India is \
$2.264\text{ trillion}$2.264 trilliondollar sign, 2,
point, 264, start text, space, t, r, i, l, l, i, o, n, end text in
2016, this means that this is the value of all new goods
product and services that were produced inside the border of India,
(GDP) excluding intermediate goods, during 2016.
one of the three approaches to calculating GDP that

involves adding up all spending on final goods and
services in an economy; the expenditures approach
categories this spending into five categories:
expenditures consumption, investment, government spending, exports,
approach to and imports: Y=C+I+G+X-MY=C+I+G+X−MY,
GDP equals, C, plus, I, plus, G, plus, X, minus, M.
an approach to calculating GDP that involves adding up

income all of the income earned within the borders of a country in
approach to a given year; the income approach adds up wages, rents,
GDP interest, and profits.
an approach to calculating GDP that involved adding up
all of the value added at various stages of production; for
example, in the production of a cake that sells for \
$12$12dollar sign, 12, the value-added approach counts
the value of the raw ingredients that a farmer sells to the
value-added baker (\$4$4dollar sign, 4), which a baker then combines
approach to with her capital to create a cake, which adds \$8$8dollar
GDP sign, 8 in value.
Term Definition
the goods and services that are purchased by consumers,
businesses, the government, or other countries in their
final form for their intended final use; for example, a car
final goods purchased by a household, a haircut, or a laptop bought by
and services a student.
goods that are used in the production of a final product;

for example, tires are final goods when Katherine buys
them at the tire store. But when Acme Motor Company
intermediate buys tires to build a car that they plan on selling, those
goods tires would be considered intermediate goods.
when using the expenditures approach, “C” is the

category of GDP that is spending by households on final
consumption goods and services in a given year but excludes spending
(C) on new housing
when using the expenditures approach, “I” is the category

of GDP that is spending businesses do in order to produce
goods and services (such as buy computers for
accountants to use or build factories to build cars);
investment investment includes spending on capital goods (tools,
(I) equipment) and inventory.
government when using the expenditures approach, “G” is the

spending (G) spending by government entities, whether local or
national governments, on goods and services such as
building roads and national defense; note that transfer
payments are not included in “government spending” in
Term Definition
GDP even though it is something that is part of the money
that a government might spend each year.
any payment by a government to a household that is not in

exchange for a good or service; for example, if the
government hires a contractor they are buying a service
that is included in GDP, but if they send a retired person a
transfer pension check they are not buying a good or service and it
payment is not counted in GDP.
goods that are produced in one country and then sold

within another country; for example, if a producer in the
United States makes 400400400 Katnest Evergreen
bobblehead dolls and sells them to a store in Japan, these
exports (X) dolls would be counted as Exports for the United States.
goods that are produced in a different country than where

they were purchased; for example, those bobblehead dolls
made in the U.S. are purchased by Japanese consumers, so
they would get counted initially as consumption (“C”) for
Japan. Since they do not reflect something that was
produced in Japan, they are subtracted from Japan’s GDP
imports (M) as an import (“M”).
net exports spending on exports minus spending on imports’

X-M “exports” is the value of goods that go out of a country,
“imports” is the value of the goods that come into a
country. There is a trade deficit when imports are higher
than exports and there is a trade surplus and when exports
Term Definition
are higher than imports.
Key Takeaways
Gross Domestic Product (GDP)

Gross domestic product (GDP) is a measure of the final output of a nation’s
economy. GDP measures the total value of all new goods and services
produced in an economy in a given year.
For example, in 2016 GDP in Japan was \$4.939\text{ trillion}

$4.939 trilliondollar sign, 4, point, 939, start text, space, t, r, i, l, l, i, o, n, end
text. This means that during 2016, Japan produced goods and services within
its geographic borders that were sold for \$4.939 \text{ trillion}
$4.939 trilliondollar sign, 4, point, 939, start text, space, t, r, i, l, l, i, o, n, end
text. GDP can be measured using 1) the expenditures approach, 2) the income
approach, or 3) the value added approach. The three approaches are
equivalent—regardless of which approach you use you should end up with
the same value.
The circular flow diagram

GDP can be represented by the circular flow diagram as a flow of income
going in one direction and expenditures on goods, services, and resources
going in the opposite direction. In this diagram, households buy goods and
services from businesses and businesses buy resources from households.
Key Graphical Model: The circular flow
diagram
The circular flow diagram has a box representing households and another box
representing firms. An arrow pointing from households to firms represents the
flow of resources. An arrow pointing from firms to households represents the
flow of goods and services. Collectively these two arrows represent the flow
of goods, services, and resources in a clockwise way. An arrow pointing from
households to firms represents spending by households on goods and firms
revenues. An arrow pointing from firms to households represents payments
made by firms to households. Collectively, these two arrows represent the
flow of income in a counterclockwise way.
Figure 1: The circular flow diagram
The circular flow diagram illustrates the equivalence of the income approach
and expenditures approach to calculating national income. In this diagram,
goods, services, and resources move clockwise, and money (income from the
sale of the goods, services, and resources) moves counterclockwise.
Individuals purchase goods and services from businesses, and their

expenditures (the money they spend) go to businesses. Firms purchases
resources, such as labor from households, and the money they pay for these
resources go to households.
Key Mathematical Model: Two approaches to

measuring GDP
The expenditures approach

GDP can be calculated using the expenditures approach using the following
equation:
Y=C+I+G+X-MY=C+I+G+X−MY, equals, C, plus, I, plus, G, plus, X,
minus, M
Each component is described in the table below:
Categor
y definition
CCC consumption: spending by households
III investment: spending by businesses on capital and inventory
government spending: spending by all government entities on

GGG goods and services (but not transfer payments)
Categor
y definition
exports: goods and services produced within a country that are
XXX purchased in other countries
imports: goods and services that are produced in other

MMM countries but are purchased in your country.
[Got it!]
For example, in 2016: Households in the nation of Fredonia spent \$200\text{

million}$200 milliondollar sign, 200, start text, space, m, i, l, l, i, o, n, end
text on newly-produced goods and services. \$40\text{ million}
$40 milliondollar sign, 40, start text, space, m, i, l, l, i, o, n, end text was
spent by businesses on adding goods to their inventories and on new
equipment to produce goods. The government spent a total of \
$35\text{ million}$35 milliondollar sign, 35, start text, space, m, i, l, l, i, o, n,
end text on goods and services. Additionally, businesses produced \
end text in goods and services that they sold overseas. Of all the goods and
services purchased in the economy, \$15\text{ million}$15 milliondollar
sign, 15, start text, space, m, i, l, l, i, o, n, end text were imported from
overseas. Therefore, Fredonia’s GDP would be calculated as:
Y= \$200 + \$40 +\$35 + \$10 - \$15 = \$260\text{ million}Y=$200+$40+

$35+$10−$15=$260 millionY, equals, dollar sign, 200, plus, dollar sign, 40,
plus, dollar sign, 35, plus, dollar sign, 10, minus, dollar sign, 15, equals,
dollar sign, 260, start text, space, m, i, l, l, i, o, n, end text.
The income approach

GDP can be calculated using the income approach using the following
equation:
Y=w+i+r+pY=w+i+r+pY, equals, w, plus, i, plus, r, plus, p
Where each category refers to the income received from supplying one of the
four economic resources:
Categor
y definition
www wages earned from labor
iii interest earned on capital
rrr rent earned on land
ppp profits earned on entrepreneurial talent
[Got it!]
In 2016, \$190\text{ million}$190 milliondollar sign, 190, start text, space,

m, i, l, l, i, o, n, end text was income earned on labor.\$25\text{ million}
$25 milliondollar sign, 25, start text, space, m, i, l, l, i, o, n, end text was
earned in interest payments.\$30\text{ million}$30 milliondollar sign, 30,
start text, space, m, i, l, l, i, o, n, end text is earned on rents collected and \
end textearned in profits. Therefore, Fredonia’s GDP is calculated asY=\$190
+ \$25 + \$30 + \$15Y=$190+$25+$30+$15Y, equals, dollar sign, 190, plus,
dollar sign, 25, plus, dollar sign, 30, plus, dollar sign, 15
Common misperceptions
 When people casually use the word “investments” in everyday
language, they are typically referring to financial assets such as stocks and
bonds. However, in the context of GDP, “investment” means real assets—the
spending on physical equipment, research and development, and inventory.
For example, if a company buys a computer, that is physical equipment. If a
company restocks its warehouse, that is building inventory. Both the
equipment and inventory are counted in the investment category of GDP. A
share of stock of a company is not considered an “investment” because it is
an ownership claim rather than a real asset. When reading or writing about
anything involving investment, make sure to specify whether you mean a real
asset or a financial asset.
 Not all government spending is counted in GDP; only what a

government spends on goods and services is counted. In many countries,
governments also have social welfare programs that do things like provide
pensions for retired people or allocate money to people with lower incomes.
These payments, called “transfer payments,” neither reflect actual production
of a good by the person receiving the money nor a service provided by the
person receiving the money. Therefore, they should not be counted in GDP.
Nobody is “buying” grandma when she gets a pension check!
Discussion Questions
 Why are imported goods deducted from the calculation of GDP?
[Got it!]
The objective of GDP is to capture what is produced in your country. One of

the more straightforward ways of doing this is to add up what is spent on
goods and services by households, businesses, and the government. The
problem with this approach is that not everything that households, businesses,
and the government purchases every year is actually produced in their
country. This means imports (goods produced in another country) must be
subtracted in order to accurately capture what was produced in your country.
 Give three examples of goods that your household purchased last year
that would not be counted in GDP.
 What does the circular flow diagram say about the relationship between
the expenditures approach and the income approach to calculating GDP?
Beyond GDP: other ways to measure the economy
Key points
 Gross national product, or GNP, includes what is produced
domestically and what is produced by domestic labor and business abroad in
a year.
 National income includes all income earned: wages, profits, rent, and

profit income.
 Net national product, or NNP, is GNP minus depreciation.
 Depreciation is the process by which capital ages over time and

therefore loses its value.
Introduction
Gross domestic product, GDP, is one way of measuring the size of the
economy—but it's not the only way. We can also measure the size of the
economy by calculating gross national product, GNP, or net national product,
NNP.
Gross national product
One of the closest cousins of GDP is gross national product. GDP includes
only what is produced within a country’s borders. GNP adds what is
produced by domestic businesses and labor abroad and subtracts out any
payments sent home to other countries by foreign labor and businesses
located in the United States.
Another way to think about is that GNP is based more on the production of
citizens and firms of a country—wherever they are located—and GDP is
based on what happens within the geographic boundaries of a certain country.
For the United States, the gap between GDP and GNP is relatively small; in
recent years, only about 0.2%. For small nations, which may have a
substantial share of their population working abroad and sending money back
home, the difference can be substantial.
Net national product

Net national product is calculated by taking GNP and then subtracting the
value of how much physical capital is worn out—or reduced in value because
of aging—over the course of a year. The process by which capital ages and
loses value is called depreciation. The NNP can be further subdivided
into national income, which includes all income to businesses and individuals
and personal income, which includes only income to people.
For practical purposes, it is not vital to memorize these definitions. However,

it is important to be aware that these differences exist and to know what
statistic you are looking at, so that you do not accidentally compare, say,
GDP in one year or for one country with GNP or NNP in another year or
another country.
Calculating GDP, net exports, and NNP
Let's look at a problem together to see the differences between these different
ways of measuring the economy.
Based on the information in the table below, what is the value of GDP? What
is the value of net exports? What is the value of NNP?
Government purchases $120 billion
Depreciation $40 billion
Consumption $400 billion
Business investment $60 billion
Exports $100 billion
Imports $120 billion
Income receipts from rest of the world $10 billion
Income payments to rest of the world $8 billion

Step 1. To calculate GDP use the following formula, where consumption
is \text{C}Cstart text, C, end text, investment is \text{I}Istart text, I, end text,
government is \text{G}Gstart text, G, end text, and exports
are \text{X}Xstart text, X, end text, and imports are \text{M}Mstart text, M,
end text:
GDP = C + I + G + (X - M)}
=400 + 60 +120 + (100-120) = 560
GDP = C + I + G + (X - M) = 400+60+120+(100−120)=
560 billion
Step 2. To calculate net exports, subtract imports from exports.
Net exports = (X - M) = 100 -120 = - 20
Net exports=(X - M)= 100−120=−20 billion
Step 3. To calculate NNP, use the following formula:
NNP = GDP + Income Receipts – Income Payments –
Depreciation = $560 + $10 - $8 - $40 = $522
NNP=GDP+ Income Receipts –Income Payments –
Depreciation = $560+$10−$8−$40= $522 billion
[Attribution]
How well GDP measures the well-being of society
Key points
 GDP is an indicator of a society’s standard of living, but it is only a
rough indicator because it does not directly account for leisure,
environmental quality, levels of health and education, activities conducted
outside the market, changes in inequality of income, increases in variety,
increases in technology, or the—positive or negative—value that society may
place on certain types of output.
 The standard of living is all elements that affect people’s happiness,

whether these elements are bought and sold in the market or not.
Introduction
You might have heard the term standard of living before—it means all of the
elements that contribute to a person's happiness.
Standard of living is a broad term that encompasses many factors—including
some that are not bought and sold in the market and some that are. The level
of GDP per capita, for instance, captures some of what we mean by the term
standard of living, as illustrated by the fact that most of the migration in the
world involves people who are moving from countries with relatively low
GDP per capita to countries with relatively high GDP per capita.
To understand the limitations of using GDP to measure the standard of living,

it is useful to spell out some things that GDP does not cover that are relevant
to standard of living.
Limitations of GDP as a measure of standard of

living
Because many factors that contribute to people's happiness are not bought
and sold, GDP is a limited tool for measuring standard of living. To
understand it's limitations better, let's take a look at several factors that are
not accounted for in GDP.
GDP does not account for leisure time. The US GDP per capita is larger than
the GDP per capita of Germany, but does this prove that the standard of
living in the United States is higher? Not necessarily since it is also true that
the average US worker works several hundred hours more per year more than
the average German worker. The calculation of GDP does not take German
workers extra weeks of vacation into account.
GDP includes what is spent on environmental protection, healthcare, and

education, but it does not include actual levels of environmental cleanliness,
health, and learning. GDP includes the cost of buying pollution-control
equipment, but it does not address whether the air and water are actually
cleaner or dirtier. GDP includes spending on medical care, but it does not
address whether life expectancy or infant mortality have risen or fallen.
Similarly, GDP counts spending on education, but it does not address directly
how much of the population can read, write, or do basic mathematics.
GDP includes production that is exchanged in the market, but it does not
cover production that is not exchanged in the market. For example, hiring
someone to mow your lawn or clean your house is part of GDP, but doing
these tasks yourself is not part of GDP.
[Hide explanation.]
One remarkable change in the US.economy in recent decades is that, as of

1970, only about 42% of women participated in the paid labor force. By the
second decade of the 2000s, nearly 60% of women participated in the paid
labor force, according to the Bureau of Labor Statistics.
As women are now in the labor force, many of the services they used to
produce in the nonmarket economy—like food preparation and child care—
have shifted to some extent into the market economy, which makes the GDP
appear larger even if more services are not actually being consumed.
GDP has nothing to say about the level of inequality in society. GDP per
capita is only an average. When GDP per capita rises by 5%, it could mean
that GDP for everyone in the society has risen by 5% or that the GDP of
some groups has risen by more while the GDP of others has risen by less—or
even declined.
GDP also has nothing in particular to say about the amount of variety
available. If a family buys 100 loaves of bread in a year, GDP does not care
whether they are all white bread or whether the family can choose from
wheat, rye, pumpernickel, and many others—GDP just looks at whether the
total amount spent on bread is the same.
Likewise, GDP has nothing much to say about which technology and
products are available. The standard of living in, for example, 1950 or 1900
was not affected only by how much money people had—it was also affected
by what they could buy. No matter how much money you had in 1950, you
could not buy an iPhone or a personal computer.
In certain cases, it is not clear that a rise in GDP is even a good thing. If a city
is wrecked by a hurricane and then experiences a surge of rebuilding
construction activity, it would be peculiar to claim that the hurricane was
therefore economically beneficial. If people are led by a rising fear of crime
to pay for installation of bars and burglar alarms on all their windows, it is
hard to believe that this increase in GDP has made them better off. In that
same vein, some people would argue that sales of certain goods, like
pornography or extremely violent movies, do not represent a gain to society’s
standard of living.
Does a rise in GDP overstate or understate the

rise in the standard of living?
The fact that GDP per capita does not fully capture the broader idea of
standard of living has led to a concern that the increases in GDP over time are
illusory. It is theoretically possible that while GDP is rising, the standard of
living could be falling if human health, environmental cleanliness, and other
factors that are not included in GDP are worsening. Fortunately, this fear
appears to be overstated.
In some ways, the rise in GDP actually understates the actual rise in the
standard of living. For example, the typical workweek for a US worker has
fallen over the last century from about 60 hours per week to less than 40
hours per week. Life expectancy and health have risen dramatically, and so
has the average level of education.
Since 1970, the air and water in the United States have generally been getting
cleaner. New technologies have been developed for entertainment, travel,
information, and health. A much wider variety of basic products like food
and clothing is available today than several decades ago. GDP does not
capture leisure, health, a cleaner environment, the possibilities created by
new technology, or an increase in variety.
On the other side, rates of crime, levels of traffic congestion, and inequality
of incomes are higher in the United States now than they were in the 1960s.
Moreover, a substantial number of services that used to be provided,
primarily by women, in the nonmarket economy are now part of the market
economy that is counted by GDP. By ignoring these factors, GDP would tend
to overstate the true rise in the standard of living.
GDP is rough, but useful

A high level of GDP should not be the only goal of macroeconomic policy—
or broader government policy. But, even though GDP does not measure the
broader standard of living with any precision, it does measure production
well, and it does indicate when a country is materially better or worse off in
terms of jobs and incomes. In most countries, a significantly higher GDP per
capita occurs hand in hand with other improvements in everyday life along
many dimensions, like education, health, and environmental protection.
No single number can capture all the elements of a concept as broad as

standard of living. Nonetheless, GDP per capita is a reasonable, rough-and-
ready measure of the standard of living.
[Hide explanation.]
To determine the state of the economy, we need to examine economic

indicators, such as GDP. Calculating GDP is quite an undertaking. It is the
broadest measure of a nation’s economic activity, and we owe a debt to
Simon Kuznets, the creator of the measurement, for that.
The sheer size of the US economy as measured by GDP is huge—as of the

third quarter of 2013, $16.6 trillion worth of goods and services were
produced annually. Real GDP informs us that the recession of 2008 to 2009
was a severe one and that the recovery from that has been slow but is
improving. GDP per capita gives a rough estimate of a nation’s standard of
living.
Summary
 GDP is an indicator of a society’s standard of living, but it is only a
rough indicator because it does not directly account for leisure,
environmental quality, levels of health and education, activities conducted
outside the market, changes in inequality of income, increases in variety,
increases in technology, or the—positive or negative—value that society may
place on certain types of output.
 The standard of living is all elements that affect people’s happiness,

whether these elements are bought and sold in the market or not.
Self-check question
Explain briefly whether each of the following would cause GDP to overstate
or understate the degree of change in the broad standard of living.
 The environment becomes dirtier.
 The crime rate declines.
 A greater variety of goods become available to consumer.s
 Infant mortality declines.
[Hide solution.]
A dirtier environment would reduce the broad standard of living, but it would
not be counted in GDP, so a rise in GDP would overstate the standard of
living.
A lower crime rate would raise the broad standard of living, but it would not
be counted directly in GDP, so a rise in GDP would understate the standard
of living.
A greater variety of goods would raise the broad standard of living, but it
would not be counted directly in GDP, so a rise in GDP would understate the
rise in the standard of living.
A decline in infant mortality would raise the broad standard of living, but it
would not be counted directly in GDP, so a rise in GDP would understate the
rise in the standard of living.
Review question
List some of the reasons why GDP should not be considered an effective
measure of the standard of living in a country.
Critical thinking questions

How might a “green” GDP be measured?
Lesson summary: The limitations of GDP
Lesson overview
Alas, nothing is perfect. And GDP is no exception. As much as economists
like to use GDP as a measure of output, or even as a measure of a country’s
well being, GDP has some limitations when trying to answer those questions.
GDP leaves out some production in an economy, such as the squash your
mom might grow in the backyard, or other non-marketed goods. Even though
GDP is frequently used to capture the wellbeing of a society, it was never
intended to do that, and as a result it leaves out important aspects of well-
being like pollution or even happiness.
Key terms
Key Terms definition
(sometimes called “well-being”) the standard of health,
happiness, security, and material comfort of an
quality of life individual, a group of people, or a nation
economic activity that takes place in the informal

sector (from babysitting, to lawn mowing, to illegal
drug sales), sometimes called the gray market or the
black market economy; non-market transactions are
not recorded, taxed, or officially monitored by the
government. Because of this, the output and income
non-market generated is not included in the calculation of a
transactions nation’s GDP.
income when a disproportionate share of a nation’s income is

earned by a small minority of households; for example,
when the top 10\%10%10, percent of households
earn 80\%80%80, percent of the total income in a
country, there is a high degree of income inequality;
GDP does not account for income distribution in any
inequality way.
the ability of a system to endure indefinitely into the

future; an increase in GDP will only be sustainable as
long as it does not deplete natural resources too rapidly
nor exploit the environment in a way that diminishes
sustainability the quality of life of the nation’s households over time.
any outcome from economic activity that creates

negative value for society, such as air pollution from
cars that harms human health and the environment;
unsustainable economic growth may diminish the
economic bads quality of life of a nation’s people.
the real gross domestic product of a nation, divided by

real GDP per the nation’s population; this measure is an indication
capita of the average income of a nation’s people
the decrease in the value of a nation’s capital stock

over time; GDP accounts for investment in new capital
but does not subtract the lost value of depreciated
capital. Because of this, GDP may overstate the
depreciation of amount of economic activity in nations with rapidly
capital depreciating capital stocks.
Human a composite measure of nation’s social and economic
Development development developed by the United Nations that
Index (HDI) includes measures of health, wealth, and education
a measure of a nation’s quality of life that includes the

income and output measured by gross domestic
product. This measure subtracts out the costs of
negative effects related to economic growth such as
crime, environmental degradation, resource depletion,
and the costs of climate change. GPI nets the positives
Genuine and negatives of economic activity to provide a more
Progress accurate measure of a nation’s quality of life than GDP
Indicator (GPI) alone.
a measure of a nation’s quality of life that includes

survey results on happiness, life expectancy at birth,
Happy Planet the degree of inequality across society, and the
Index (HPI) ecological footprint
Key takeaways
The limitations of GDP

GDP is a useful indicator of a nation’s economic performance, and it is the
most commonly used measure of well-being. However, it has some important
limitations, including:
 The exclusion of non-market transactions

 The failure to account for or represent the degree of income inequality
in society
 The failure to indicate whether the nation’s rate of growth is sustainable
or not
 The failure to account for the costs imposed on human health and the
environment of negative externalities arising from the production or
consumption of the nation’s output
 Treating the replacement of depreciated capital the same as the creation
of new capital
Alternative indicators have been developed to provide a more well-rounded
measure of a nation’s quality of life by different national and international
organizations. These include:
 The Human Development Index (HDI)

 The Genuine Progress Indicator (GPI)
 The Happy Planet Index (HPI)
Each of these indexes is a composite measure weighing both income and
non-income variables such as life expectancy, literacy rates, environmental
indicators, measures of inequality and so on. By including these variables,
they provide a measure of life quality that goes beyond the narrowness of a
nation’s GDP value.
 Some people mistakenly think a higher income (and larger GDP) is
correlated with a higher quality of life and more happiness, but only up to a
certain income level. Some studies have actually found that beyond a certain
income level, additional increases in income are no longer correlated with
higher quality of life. Instead, other, non-income factors (such as the equity
of income distribution and access to education and health-care) are more
closely correlated with a happier, healthier society.
 Some of the poorest countries in the world may actually appear poorer
than they really are if we only consider their official GDP figures. If a large
percentage of the workforce is employed in the informal sector, then their
incomes will not be reflected in the nation’s GDP. As a result, the nation’s
GDP will appear smaller than it would be if all economic activity were
included.
Discussion questions
1. Do higher incomes and more output always equal a higher quality of
life for the people experiencing such growth? Explain.
2. Under what circumstances would an increase in a nation's average

income not lead to an increase in the income of the typical, median
household?
3. Choose an alternative measure of well-being and describe what it

includes.
[Thanks!]
The Human Development Index is a measure that was developed by

economist Mahbub ul Haq with the goal of shifting attention away from
measures like GDP to a more people-centric measure of well-being. Its uses
measured that are meant to capture three dimensions of well-being: a long
and healthy life, knowledge, and a decent standard of living.
Lesson summary: Unemployment
Lesson overview
A country’s economic performance is measured using three key indicators,
one of which is the unemployment rate. When adults who are willing and
able to work cannot find a job, it may be a sign that an economy is producing
less than it could. On the other hand, unemployment is also a natural
phenomenon that even healthy economies experience. While the official
unemployment rate is helpful in representing the state of a nation’s
workforce, it does have some shortcomings that should be considered, such
as excluding discouraged workers.
There are three types of unemployment that economists

describe: frictional, structural, and cyclical. During recessions and
expansions, the amount of cylical unemployment changes. Cyclical
unemployment is closely related to the business cycle, and causes the
deviations of the current rate of unemployment away from the natural rate
of unemployment.
Key Terms
Key Term Definition
when people are not working, but they are actively
looking for work; for example, Glenn did not work at
all last week, though he tried to find a job, so he is
unemployment considered unemployed.
a term that describes a person who could be working,

and wants to work, but is not working; to be counted
as unemployed you must be part of the eligible
population, not working, and actively looking for
unemployed work.
Key Term Definition
unemployment
rate the percentage of the labor force that is unemployed
the number of people in a population who are either

labor force employed or unemployed
these are the people deemed likely to be in the labor

force; for example, in the United States, the eligible
population in the US is anyone 16 years of age or
eligible older who is not institutionalized (i.e., not in prison)
population and not in the military.
labor force the percentage of the eligible population that is in the

participation rate labor force
people who do not have a job, but they will take a job
if offered one. However, they have given up looking
for work, so they are not counted in the labor force;
for example, if Carol gives up looking for work
because she is having trouble finding a job, she is no
discouraged longer in the labor force and therefore is not counted
workers as unemployed.
people who work part-time, but they really want to

work full time if they could find a full-time job; for
example, Tyreese wants to work full time as an
underemployed engineer, but he can only find a part-time job.
full employment (also called the full employment real output) the

output amount of output that is produced in an economy
when that economy is using all of its resources
Key Term Definition
efficiently; the full employment output would be a
combination of output that is on that country’s PPC.
the unemployment rate that exists when an economy

is producing the full employment output; when an
economy is in a recession, the current unemployment
rate is higher than the natural rate. During
natural rate of expansions, the current unemployment rate is less
unemployment than the natural rate.
the component of the natural rate of unemployment

that occurs because the job search process is not
instantaneous; for example, after Rosita graduated
from dental school, it took her a few weeks to find a
frictional job as a dentist. During this period she will be
unemployment frictionally unemployed.
unemployment that occurs as a result of a structural

change in the economy, such as the development of a
new technology or industry; this is a part of the
natural rate of unemployment. For example, Negan
finds a cure for all dental diseases, and as a result,
structural Rosita loses her job as a dentist and is now
unemployment structurally unemployed.
cyclical the unemployment associated with the recessions and

unemployment expansions; this can have a positive or negative
value. The current unemployment rate will depend on
both the natural rate of unemployment and the
Key Term Definition
amount of cyclical unemployment at the time.
Key takeaways
The labor force participation rate (LFPR)

The labor force participation rate (LFPR) is another measure of labor market
activity in the economy. The LFPR is the percentage of the adult population
that is in the labor force. The labor force includes everyone who is either
employed or unemployed. The adult population is defined as anyone who is
over the age of 16 who potentially could be part of the labor force. Anyone
who is less than 16 years old, is in the military, or is institutionalized is not
considered to be potentially part of the labor force and is excluded from this
calculation.
When people enter the labor force the LFPR increases, and when people exit
the labor force the LFPR decreases. A decrease in the LFPR that occurs at the
same time as a decrease in the unemployment rate can signal that there are
more discouraged workers.
Limitations of the unemployment rate

The unemployment rate as it is measured officially is often criticized for
understating the level of joblessness because it excludes anyone working at
all or people who aren’t looking for work. In particular, the official
unemployment rate leaves out discouraged workers and the underemployed.
People who have given up looking for work because they are convinced that
they cannot find jobs are considered discouraged workers. Some people are
counted as employed because they are working part-time, even though they
really want full-time work.
Three types of unemployment

Economists primarily focus on three types of unemployment: cyclical,
frictional, and structural. Cyclical unemployment is the unemployment
associated with the ups and downs of the business cycle. During recessions,
cyclical unemployment increases and drives up the unemployment rate.
During expansions, cyclical unemployment decreases and drives down the
unemployment rate.
[Hide this, please.]
Sure! The deviation of the actual unemployment rate from the natural rate is
cyclical unemployment. Cyclical unemployment is higher in recessions and
lower during expansions. If an economy is producing less than full
employment output (meaning it is operating inside its PPC), then the actual
unemployment rate is higher than the natural rate.
For example, if the natural rate of unemployment is five percent, but the
unemployment rate is currently seven percent, there is cyclical
unemployment of two percent. Cyclical unemployment can also be negative
—if the economy is producing beyond its efficient level and is in the
expansion phase of the business cycle (operating outside of its PPC), then
cyclical unemployment is negative.
The actual unemployment rate is lower than the natural rate of

unemployment. What is actually going on is that some people who are
frictionally unemployed become employed, even though under normal
circumstances they would still be unemployed. When firms get desperate for
workers, they might be more willing to hire whoever they can, even if that
person is not a great fit for the job.
The natural rate of unemployment

The natural rate of unemployment (NRU) is the unemployment rate that
exists when the economy produces full-employment real output. NRU is
equal to the sum of frictional and structural unemployment. When an
economy is producing an efficient amount of output (meaning it is operating
on its PPC), the unemployment rate will be equal to the natural rate of
unemployment. Even though an economy may be operating efficiently, there
will still be some unemployment. Because of that, the natural rate of
unemployment is never equal to zero.
Frictional unemployment is the unemployment associated with looking for

jobs, such as recent college graduates looking for their first jobs. Any
innovation that makes finding a job easier, such as job-search websites or
apps, decreases the amount of frictional unemployment.
Structural unemployment occurs because skills that employers need from

workers changes as the nature of the economy changes. This can occur when
new types of goods or technologies are introduced. For example, if someone
created a robot that could train fleas to dance, then people who worked in the
flea performance industry no longer have skills that are valued. They become
structurally unemployed until they learn a new skill.
Changes in the natural rate of unemployment (NRU)

The natural rate of unemployment (NRU) can gradually change over time due
to events such as changes in labor force characteristics. The NRU can change
due to changes in structural and frictional unemployment. For example, a
firm may want to hire fewer workers because the skills of those workers are
not needed as much as they used to be. That will cause more structural
unemployment, and the natural rate of unemployment will increase.
Key Equations
The labor force:

The labor force is made up of the number of people unemployed and the
number of people employed:
LF=# Unemployed+# Employed
To be employed you must have worked at all (even just one hour) for pay in
the “reference week” (the week that you are being asked about). To be
counted as unemployed you must not have worked at all in the reference
week and be actively looking for work.
The labor force participation rate (LFPR)

The LFPR is the percentage of the eligible population that is in the labor
force.
LFPR = \dfrac{LF}{\text{Eligible Population}}\times
100\%LFPR=Eligible PopulationLF×100%L, F, P, R, equals, start
fraction, L, F, divided by, start text, E, l, i, g, i, b, l, e, space, P, o, p, u, l, a, t,
i, o, n, end text, end fraction, times, 100, percent
People are not considered part of the eligible population if they are not
working age (defined as 161616 years or older), institutionalized (for
example, in prison), or in the military.
The unemployment rate (UR)

The unemployment rate is the percentage the labor force that is unemployed.
UR=# Unemployed# in Labor Force×100%
Let’s use the people in a college classroom as an example of a population.

Let’s calculate the UR and the LFPR for this population.
The table below describes each student in BSKW 101- Introduction to

Underwater Basket Weaving:
Person Description:
Professor The professor who teaches underwater basket
1 Dodge weaving full time
A 22-year-old economics major who is graduating

2 Abby soon and looking for a consulting job
A 19-year-old Environmental Science major who

3 Kevin works part-time in a lab
A 23-year-old economics major who works full-time

4 JJ at a restaurant
A precocious 12-year-old who graduated from high

5 Max school at age 11
6 Isidore A 70-year-old retiree who takes college classes for

Person Description:
fun and will never work again
A 20-year French major who is looking for a full-time

7 Alisdair job
8 Anat A 21-year-old physics major who works full time
A 19-year-old who wants a full-time job but can only

9 Mireille find part-time work
1
0 Amal An 18-year-old who is looking for a part-time job.
1 Professor Dodge’s paid teaching assistant who is 28

1 Han years old
First, we start by determining who is in our eligible population: Prof. Dodge,
Abby, Kevin, JJ, Isidore, Alisdair, Anat, Mireille, Amal, and Han are all part
of the eligible population because they are over the age of 16, not in the
military, and not in an institution (such as a prison). Max is not in the eligible
population because he is too young.
Next, we determine who is employed and who is unemployed. Together, the

employed and unemployed comprise the labor force (LF). Prof. Dodge,
Kevin, JJ, Anat, Mireille, and Han are considered employed because they
work for pay. Abby, Alisdair, and Amal are all unemployed because they are
out of work and looking for work. Therefore there are six people employed,
three people unemployed, and a total of nine people who are in the labor
force. What about Isidore? Even though he isn’t working he isn’t looking for
a job, so he is not counted as unemployed. Instead, Isidore is considered “not
in the labor force.”
The labor force participation rate is:
\begin{aligned}LFPR &=\dfrac{LF}{\text{Eligible Population}}\times

100\%\\ \\ &=\dfrac{9}{10}\times 100\%\\ \\ &=90\%\end{aligned}LFPR
=Eligible PopulationLF×100%=109×100%=90%
The unemployment rate is (rounded to the nearest percent):
\begin{aligned}UR &=\dfrac{\text{Unemployed}}{\text{Labor
Force}}\times 100\%\\ \\ &=\dfrac{3}{9}\times 100\%\\ \\
&=33\%\end{aligned}UR=Labor ForceUnemployed×100%=93×100%=33%
Common Misperceptions
 Not everyone who is out of work is unemployed. In order to be counted
as unemployed you have to be out of work, looking for work, and able to
accept a job if one is offered to you. If you are out of work and not looking,
then you are considered “not in the labor force” rather than unemployed.
 We tend to think of unemployment as an undesirable thing, but a
certain amount of unemployment is actually part of a healthy economy.
Structural unemployment occurs when new industries are created and old
industries become obsolete. For example, when we moved from using horses
and buggies to using cars to get around, this put a lot of buggy makers in the
structurally unemployed category.
 Frictional unemployment might not seem very fun, but consider what it
means to have zero unemployment—nobody ever looks for a job, they just
remain in whatever job they are given! In fact, a number of dystopian novels
have been written in which everyone in a society is automatically assigned a
fixed career (such as the Divergent series). Those societies have zero
frictional unemployment, but they are also quite unpleasant if you are
unhappy with that career!
 A decrease in the unemployment rate isn’t necessarily a sign of an
improving economy. When people stop looking for jobs and drop out of the
labor force as discouraged workers, the unemployment rate will decrease
even though the true employment situation hasn’t gotten any better. This is
why it is important to look at both changes in the unemployment rate and
changes in the labor force participation rate. Looking at both changes let’s
you get a more complete idea about changes in the employment situation.
Discussion Questions:
1. An inventor in Burginville developed a fantastic new dictation machine
that perfectly records speech and turns it into a typed document.
Unfortunately, that meant that unemployment increased among typists
working in offices. Which type of unemployment is this? Explain.
This is structural unemployment because typists skills are no longer desired.

The changing structure of office work has resulted in people losing their jobs.
2. The nation of Fitlandia has 120,000120,000120, comma, 000 people.

Of these, 20,00020,00020, comma, 000 are children under the age of
16, 72{,}00072,00072, comma, 000 have jobs, 8{,}0008,0008, comma,
000 don’t have jobs and are looking for work, and 20{,}00020,00020,
comma, 000 people are retired. Assuming that these are all
noninstitutionalized civilians, calculate the labor force participation rate and
the unemployment rate.
LFLFPRUR=# Employed+#
Unemployed=72,000+8,000=80,000=LFEligible
Population×100%=80,000100,000×100%=80%=#
Unemployed# Labor Force×100%=8,00080,000×100%=10%
3. Explain why a decrease in the unemployment rate can actually signal a
tough job market.
Explanation: If unemployed workers give up looking for jobs, they become

“discouraged” workers and are no longer considered part of the labor force.
But since they are no longer unemployed the nation’s unemployment rate
actually decreases. In such a scenario, a decrease in the unemployment rate is
actually a sign of a tough job market (and a weak economy).
Tracking inflation
Key points
 Price level is measured by constructing a hypothetical basket of goods
and services—meant to represent a typical set of consumer purchases—and
calculating how the total cost of buying that basket of goods increases over
time.
 The rate of inflation is measured as the percentage change between

price levels over time.
 An index number is a unit-free number derived from the price level

over a number of years that makes computing inflation rates easier.
 Inflation is the general and ongoing rise in the level of prices in an

economy.
Tracking inflation
When you hear about inflation at the dinner table, it's often a conversation
about how everything seemed to cost so much less in the past, how you used
to be able to buy three gallons of gasoline for a dollar and then go see an
afternoon movie for another dollar.
The table below compares some prices of common goods in 1970 and 2014
—but keep in mind that the average prices shown may not reflect the prices
where you live. The cost of living in New York City is much higher than in
Houston, Texas, for example. In addition, certain products have evolved over
recent decades. A new car in 2014—loaded with antipollution equipment,
safety gear, computerized engine controls, and many other technological
advances—is a more advanced machine and more fuel efficient than your
typical 1970s car.
Let's put details like these to one side for the moment, however, and look at
the overall pattern. The primary reason behind the price increases in the table
—and increases in prices of other products in the economy not shown here—
is not specific to the market for housing or cars or gasoline or movie tickets.
Instead, it is part of a general rise in the level of all prices.
In 2014, one dollar had about the same purchasing power in overall terms of
goods and services as 18 cents did in 1972 because of the amount of inflation
that has occurred over that time period.
Item 1970 2014

Pound of ground beef $0.66 $4.16
Pound of butter $0.87 $2.93
Movie ticket $1.55 $8.17

Item 1970 2014
Sales price of new home, median $22,000 $280,000
New car $3,000 $32,531
Gallon of gasoline $0.36 $3.36
Average hourly wage for a manufacturing worker $3.23 $19.55
Per capita GDP $5,069 $53,041.98

Price comparisons, 1970 and 2014
Additionally, the power of inflation does not affect just goods and services
but wages and income levels, too. The second-to-last row of the table above
shows that the average hourly wage for a manufacturing worker increased
nearly six-fold from 1970 to 2014. Sure, the average worker in 2014 is better
educated and more productive than the average worker in 1970—but not six
times more productive. And yes, per capita gross domestic product increased
substantially from 1970 to 2014, but is the average person in the US economy
really more than eight times better off in just 44 years? Not likely.
A modern economy has millions of goods and services whose prices are
continually quivering in the breezes of supply and demand. How can all of
these shifts in price be boiled down to a single inflation rate? As with many
problems in economic measurement, the conceptual answer is reasonably
straightforward. Prices of a variety of goods and services are combined into a
single price level. The inflation rate is the percentage change in the price
level. Applying the concept, however, involves some practical difficulties.
The price of a basket of goods

To calculate the price level, economists begin with the concept of a basket of
goods and services that consists of the different items individuals, businesses,
or organizations typically buy. The next step is to look at how the prices of
those items change over time.
In thinking about how to combine individual prices into an overall price

level, many people find that their first impulse is to calculate the average of
the prices. Such a calculation, however, could easily be misleading because
some products matter more than others.
Changes in the prices of goods for which people spend a larger share of their
incomes will matter more than changes in the prices of goods for which
people spend a smaller share of their incomes. For example, an increase of
10% in the rental rate on housing matters more to most people than whether
the price of carrots rises by 10%. To construct an overall measure of the price
level, economists compute a weighted average of the prices of the items in
the basket, where the weights are based on the actual quantities of goods and
services people buy.
[Hide explanation.]
Imagine a simple basket of goods containing only the three items shown in
the table below. Say that in any given month, a college student spends money
on 20 hamburgers, one bottle of aspirin, and five movies. Prices for these
items over four years are given in the table through each time period.
Prices of some goods in the basket may rise while others fall. In this example,
the price of aspirin does not change over the four years, while movies
increase in price and hamburgers bounce up and down. Each year, the cost of
buying the given basket of goods at the prices prevailing at that time is
shown.
Bottle of Inflation
Items Hamburger Asprin Movies Total rate
Quantity 20 1 5 - -
Period
one
Price $3.00 $10.00 $6.00 - -
Amount
spent $60.00 $10.00 $30.00 $100.00 -
Period
two
Price $3.20 $10.00 $6.50 - -
Amount
spent $64.00 $10.00 $32.50 $106.50 6.5%
Period
three
Price $3.10 $10.00 $7.00 - -

Amount
spent $62.00 $10.00 $35.00 $107.00 0.5%
Period
four
Price $3.50 $10.00 $7.50 - -
Amount
spent $70.00 $10.00 $37.50 $117.50 9.8%
Bottle of Inflation
Items Hamburger Asprin Movies Total rate
A college student’s basket of goods
Now, let's calculate the annual rate of inflation.
Step 1. Find the percentage change in the cost of purchasing the overall
basket of goods between the time periods. The general equation for
percentage change between two years, whether in the context of inflation or
in any other calculation, is below.
\begin{array}{ccc} \frac{\left (\mathrm{Level~ in~ new~ year~ -~ Level~

in~ previous~ year}\right )}{\mathrm{Level~ in~ previous~ year}} &
\mathrm{~ =~ } & \mathrm{Percentage~ change}
\end{array}Level in previous year(Level in new year − Level in previous year) = Percentage chan
ge
Step 2. From period one to period two, the total cost of purchasing the basket
of goods rises from $100 to $106.50. The percentage change over this time—
which we also call the inflation rate—can be calculated as shown below:
\begin{array}{ccccc} \frac{\left (\mathrm{106.50~ -~ 100}\right )}

{\mathrm{100.0}} & \mathrm{~ =~ } & \mathrm{0.065} & \mathrm{~ =~ }
& \mathrm{6.5\% } \end{array}100.0(106.50 − 100) = 0.065 = 6.5%
Step 3. From period two to period three, the overall change in the cost of
purchasing the basket rises from $106.50 to $107. Again, we calculate the
percentage change:
\begin{array}{ccccc} \frac{\left (\mathrm{107~ -~ 106.50}\right )}

{\mathrm{106.50}} & \mathrm{~ =~ } & \mathrm{0.0047} & \mathrm{~
=~ } & \mathrm{0.47\% } \end{array}106.50(107 − 106.50) = 0.0047 = 0.47%
Step 4. From period three to period four, the overall cost rises from $107 to
$117.50. The inflation rate is
\begin{array}{ccccc} \frac{\left (\mathrm{117.50~ -~ 107}\right )}

{\text{107}} & \mathrm{~ =~ } & \mathrm{0.098} & \mathrm{~ =~ } &
\mathrm{9.8\% } \end{array}107(117.50 − 107) = 0.098 = 9.8%
This calculation of the change in the total cost of purchasing a basket of

goods takes into account how much is spent on each good. Hamburgers are
the lowest-priced good in this example, and Aspirin is the highest priced. If
an individual buys a greater quantity of a low-price good, then it makes sense
that changes in the price of that good should have a larger impact on the
buying power of that person’s money. The larger impact of hamburgers
shows up in the amount spent row, where—in all time periods—hamburgers
are the largest item within the amount spent row.
Index numbers
The numerical results of a calculation based on a basket of goods can get a
little messy. To simplify the task of interpreting the price levels for
realistically complex baskets of goods, the price level in each period is
typically reported as an index number, rather than as the dollar amount for
buying the basket of goods.
Price indices are created to calculate an overall average change in relative

prices over time. To convert the money spent on the basket to an index
number, economists arbitrarily choose one year to be the base year, or
starting point from which we measure changes in prices. The base year, by
definition, has an index number equal to 100.
This might sound strange, but it's really just a math trick to simplify things.
Let's try it out. Let's say we choose a base year in which $107 is spent. We
divide that amount by itself—$107—and multiply by 100, which gives us an
index in the base year of 100. Note that the index number in the base
year always has to have a value of 100.
Then, to figure out the values of the index numbers for the other years, we
divide the dollar amounts for the other years by 1.07—the amount spent
during the base year divided by 100. Note also that the dollar signs cancel
out, so index numbers have no units.
Take a look at the table below. You'll see that in our example, we've chosen
period three as our base year—notice that total spending is $107. The index
numbers for the other three periods in the table were calculated using the
same method we used above. And—because the index numbers are
calculated so that they are in exactly the same proportion as the total dollar
cost of purchasing the basket of goods—the inflation rate can be calculated
based on the index numbers, using the percentage change formula.
Let's give it a try! The inflation rate from period one to period two can be
calculated using the formula for percentage change:
\begin{array}{ccccc} \frac{\left (\mathrm{99.5~ -~
93.4}\right )}{\mathrm{93.4}} & \mathrm{~ =~ } &
\mathrm{0.065} & \mathrm{~ =~ } & \mathrm{6.5\% }
\end{array}93.4(99.5 − 93.4) = 0.065 = 6.5%
You can see that the inflation rates for the other periods in the table were
calculated using the same formula.
Total Inflation rate since
spending Index number previous period
\frac{100}{1.07} =
93.41.07100=93.4start
fraction, 100, divided by,
Period 1, point, 07, end fraction,
1 $100 equals, 93, point, 4
\frac{(99.5 - 93.4)}
{93.4} = 0.065 =
6.5\%93.4(99.5−93.4)
=0.065=6.5%start
fraction, left
parenthesis, 99, point,
\frac{106.50}{1.07} 5, minus, 93, point, 4,
= 99.51.07106.50 right parenthesis,
=99.5start fraction, 106, divided by, 93, point, 4,
point, 50, divided by, 1, end fraction, equals, 0,
Period point, 07, end fraction, point, 065, equals, 6,
2 $106.50 equals, 99, point, 5 point, 5, percent
Period $107 \frac{107}{1.07} = \frac{(100 - 99.5)}

3– 100.01.07107=100.0start {99.5} = 0.005 =
base fraction, 107, divided by, 0.5\%99.5(100−99.5)
year 1, point, 07, end fraction, =0.005=0.5%start
equals, 100, point, 0 fraction, left
parenthesis, 100, minus,
99, point, 5, right
parenthesis, divided by,
Total Inflation rate since
spending Index number previous period
99, point, 5, end
fraction, equals, 0,
point, 005, equals, 0,
point, 5, percent
\frac{(109.8 - 100)}
{100} = 0.098 =
9.8\%100(109.8−100)
=0.098=9.8%start
fraction, left
parenthesis, 109, point,
\frac{117.50}{1.07} 8, minus, 100, right
= 109.81.07117.50 parenthesis, divided by,
=109.8start fraction, 100, end fraction,
117, point, 50, divided by, equals, 0, point, 098,
Period 1, point, 07, end fraction, equals, 9, point, 8,
4 $117.50 equals, 109, point, 8 percent
If we can calculate inflation rate correctly using either dollar values or index
numbers, then why bother with the index numbers?
The advantage is that indexing allows easier eyeballing of the inflation

numbers. If you glance at two index numbers like 107 and 110, you know
automatically that the rate of inflation between the two years is about, but not
quite exactly equal to, 3%. By contrast, imagine that the price levels were
expressed in absolute dollars of a large basket of goods, so when you looked
at the data, the numbers were $19,493.62 and $20,009.32. Most people find it
difficult to eyeball those kinds of numbers and say that it is a change of about
3%—even though the proportions are exactly the same.
[Hide explanation.]
A word of warning: When a price index moves from, say, 107 to 110, the rate
of inflation is not exactly 3%. Remember, the inflation rate is not derived by
subtracting the index numbers, but rather through the percentage-change
calculation. The precise inflation rate as the price index moves from 107 to
110 is calculated as (110 – 107) / 107 = 0.028 = 2.8%. When the base year is
fairly close to 100, a quick subtraction is not a terrible shortcut to calculating
the inflation rate—but when precision matters down to tenths of a percent,
subtracting will not give the right answer.
Two final points about index numbers are worth remembering. First, index
numbers have no dollar signs or other units attached to them. Although index
numbers can be used to calculate a percentage inflation rate, the index
numbers themselves do not have percentage signs. Index numbers just mirror
the proportions found in other data. They transform the other data so that the
data are easier to work with.
Second, the choice of a base year for the index number—that is, the year that
is automatically set equal to 100—is arbitrary. It is chosen as a starting point
from which changes in prices are tracked. In official inflation statistics, it is
common to use one base year for a few years and then to update it so that the
base year of 100 is relatively close to the present. But any base year that is
chosen for the index numbers will result in exactly the same inflation rate.
To see this in the previous example, imagine that period one—when total
spending was $100—was chosen as the base year and given an index number
of 100. At a glance, you can see that the index numbers would now exactly
match the dollar figures, the inflation rate in the first period would be 6.5%,
and so on.
Summary
 Price level is measured by constructing a hypothetical basket of goods
and services—meant to represent a typical set of consumer purchases—and
calculating how the total cost of buying that basket of goods increases over
time.
 The rate of inflation is measured as the percentage change between

price levels over time.
 An index number is a unit-free number derived from the price level

over a number of years that makes computing inflation rates easier.
 Inflation is the general and ongoing rise in the level of prices in an

economy.
The table below shows the prices of fruit purchased by the typical college
student from 2001 to 2004. What is the amount spent each year on this
hypothetical basket of fruit with the quantities shown in column two?
2001 2002 2003 2004
200 amo 200 amo 200 amo 200 amo
1 unt 2 unt 3 unt 4 unt
Quan pri spen pri spen pri spen pri spen
Items tity ce t ce t ce t ce t
$0. $0. $0. $0.
Apples 10 50 75 85 88
Banana $0. $0. $0. $0.

s 12 20 25 25 29
$0. $0. $0. $0.

Grapes 2 65 70 90 95
Raspbe $2. $1. $2. $2.

rries 1 00 90 05 13 $2.13
Total
[Show solution.]
Construct the price index for a hypothetical fruit basket in each year using
2003 as the base year.
[Hide solution.]
If 2003 is the base year, then the index number has a value of 100 in 2003. To
transform the cost of a fruit basket each year, we divide each year’s value by
$15.35—the value of the base year—and then multiply the result by 100. The
price index is shown in the following table.
2001 2002 2003 2004

69.7
1 89.90 100.00 106.3
Note that the base year has a value of 100. Years before the base year have
values less than 100. Years after the base year have values more than 100.
Calculate the inflation rate for fruit prices from 2001 to 2004.
[Hide solution.]
The inflation rate is calculated as the percentage change in the price index
from year to year. For example, the inflation rate between 2001 and 2002 is
(84.61 - 69.71) / 69.71 = 0.2137 =

21.37\%(84.61−69.71)/69.71=0.2137=21.37%left parenthesis, 84, point, 61,
minus, 69, point, 71, right parenthesis, slash, 69, point, 71, equals, 0, point,
2137, equals, 21, point, 37, percent
The inflation rates for all the years are shown in the last row of the following
table, which includes the two previous answers.
2001 2002 2003 2004

200 amo 200 amo 200 amo 200 amo
$0. $0. $0. $0.
Apples 10 50 $5.00 75 $7.50 85 $8.50 88 $8.80
Banana $0. $0. $0. $0.

s 12 20 $2.40 25 $3.00 25 $3.00 29 $3.48
$0. $0. $0. $0.

Grapes 2 65 $1.30 70 $1.40 90 $1.80 95 $1.90
Raspbe $2. $1. $2. $2.

rries 1 00 $2.00 90 $1.90 05 $2.05 13 $2.13
2001 2002 2003 2004
200 amo 200 amo 200 amo 200 amo
$10.7 $13.8 $15.3 $16.3
Total 0 0 5 1
Price 100.0
index 69.71 89.90 0 106.3
Inflatio 28.97 11.23 6.25

n rate % % %
Edna is living in a retirement home where most of her needs are taken care
of, but she has some discretionary spending. Based on the basket of goods in
the table below, by what percentage does Edna’s cost of living increase
between time one and time two?
Time one
Items Quantity Price Time two price
Gifts for
grandchildren 12 $50 $60
Pizza delivery 24 $15 $16
Blouses 6 $60 $50
Vacation trips 2 $400 $420

[Hide solution.]
Begin by calculating the total cost of buying the basket in each time period,
as shown in the following table.
Time
Time Time one two Time two
Items Quantity one price total cost price total cost
Gifts 12 $50 $600 $60 $720
Pizza 24 $15 $360 $16 $384
Blouses 6 $60 $360 $50 $300
Trips 2 $400 $800 $420 $840
Total
cost $2,120 $2,244
The rise in cost of living is calculated as the percentage increase:
(2244 - 2120) / 2120 = 0.0585 = 5.85\%.

(2244−2120)/2120=0.0585=5.85%.left parenthesis, 2244, minus, 2120, right
parenthesis, slash, 2120, equals, 0, point, 0585, equals, 5, point, 85, percent,
point
Review questions
 How is a basket of goods and services used to measure the price level?
 Why are index numbers used to measure the price level rather than
dollar value of goods?
 What is the difference between the price level and the rate of inflation?
Critical-thinking question
Inflation rates, like most statistics, are imperfect measures. Can you identify
some ways that the inflation rate for fruit does not perfectly capture the rising
price of fruit?
Problems
Problem one
The index number representing the price level changes from 110 to 115 in
one year, and then from 115 to 120 the next year. Since the index number
increases by five each year, is five the inflation rate each year? Is the inflation
rate the same each year? Explain your answer.
Problem two
The total price of purchasing a basket of goods in the United Kingdom over
four years is shown in the table below:
Year
one Year two Year three Year four
£940 £970 £1000 £1070
Calculate two price indices:
 One using year one as the base year—set equal to 100.

 One using year four as the base year—set equal to 100.
Then, calculate the inflation rate based on the first price index. If you had
used the other price index, would you get a different inflation rate? If you are
unsure, do the calculation and find out.
How changes in the cost of living are measured
Key points
 The Consumer Price Index, or CPI is a measure of inflation
calculated by US government statisticians based on the price level from a
fixed basket of goods and services that represents the purchases of the
average consumer.
 The core inflation index is a measure of inflation typically calculated

by taking the CPI and excluding volatile economic variables such as food and
energy prices to better measure the underlying and persistent trend in long-
term prices.
 The quality/new goods bias causes inflation calculated using a fixed

basket of goods over time to overstate the true rise in cost of living because
improvements in the quality of existing goods and the invention of new
goods are not taken into account.
 The substitution bias causes an inflation rate calculated using a fixed

basket of goods over time to overstate the true rise in the cost of living
because it does not take into account that people can substitute away from
goods whose prices rise disproportionately.
 Several price indices are not based on baskets of consumer goods. The
GDP deflator is based on all the components of GDP. The Producer Price
Index is based on prices of supplies and inputs bought by producers of goods
and services. The Employment Cost Index measures wage inflation in the
labor market. The International Price Index is based on the prices of
merchandise that is exported or imported.
How changes in the cost of living are measured
The most commonly cited measure of inflation in the United States is
the Consumer Price Index, or CPI. The CPI is calculated by government
statisticians at the US Bureau of Labor Statistics based on the prices in a
fixed basket of goods and services that represents the purchases of the
average family of four.
In recent years, these statisticians have paid considerable attention to a subtle

problem: the change in the total cost of buying a fixed basket of goods and
services over time is conceptually not quite the same as the change in the cost
of living because the cost of living represents how much it costs for a person
to feel that his or her consumption provides an equal level of satisfaction or
utility.
To understand the distinction, imagine that over the past 10 years, the cost of
purchasing a fixed basket of goods increased by 25% and your salary also
increased by 25%. Has your personal standard of living held constant?
If you do not necessarily purchase an identical fixed basket of goods every

year, then an inflation calculation based on the cost of a fixed basket of goods
may be a misleading measure of how your cost of living has changed. Two
problems arise here: substitution bias and quality/new goods bias.
When the price of a good rises, consumers tend to purchase less of it and to
seek out substitutes instead. Conversely, as the price of a good falls, people
will tend to purchase more of it. This pattern implies that goods with
generally rising prices should tend over time to become less important in the
overall basket of goods used to calculate inflation, while goods with falling
prices should tend to become more important.
Consider, as an example, a rise in the price of peaches by $100 per pound. If
consumers were utterly inflexible in their demand for peaches, this would
lead to a big rise in the price of food for consumers. Alternatively, imagine
that people are utterly indifferent to whether they have peaches or other types
of fruit. Now, if peach prices rise, people will completely switch to other fruit
choices and the average price of food will not change at all.
A fixed, unchanging basket of goods assumes that consumers are locked into
buying exactly the same goods, regardless of price changes—not a very
likely assumption. Substitution bias tends to overstate the rise in a
consumer’s true cost of living because it does not take into account that the
person can substitute away from goods whose relative prices have risen.
The other major problem in using a fixed basket of goods as the basis for
calculating inflation is how to deal with the arrival of improved versions of
older goods or altogether new goods. Consider the problem that arises if a
cereal is improved by adding 12 essential vitamins and minerals but costs 5%
more per box. It would be misleading to count the entire resulting higher
price as inflation because the new price is being charged for a product of
higher—or at least different—quality. Ideally, we would like to know how
much of the higher price is due to the quality change and how much of it is
just a higher price. The Bureau of Labor Statistics, or BLS, which is
responsible for the computation of the Consumer Price Index, or CPI—a
measure of inflation calculated based on the price level from a fixed basket of
goods and services that represents the purchases of the average consumer—
must deal with these difficulties in adjusting for quality changes.
A new product can be thought of as an extreme improvement in quality—

from something that did not exist to something that does. However, the
basket of goods that was fixed in the past obviously does not include new
goods created since then. The basket of goods and services used in the CPI is
revised and updated over time, so new products are gradually included. But
the process takes some time.
For example, room air conditioners were widely sold in the early 1950s but
were not introduced into the basket of goods behind the CPI until 1964.
VCRs and personal computers were available in the late 1970s and widely
sold by the early 1980s, but they did not enter the CPI basket of goods until
1987. By 1996, there were more than 40 million cellular phone subscribers in
the United States, but cell phones were not yet part of the CPI basket of
goods. The parade of inventions has continued, with the CPI inevitably
lagging a few years behind.
The arrival of new goods creates problems with respect to the accuracy of
measuring inflation as well. The reason people buy new goods, presumably,
is that the new goods offer better value for money than existing goods. Thus,
if the CPI leaves out new goods, it overlooks one of the ways in which the
cost of living is improving. In addition, the price of a new good is often
higher when it is first introduced and then declines over time. If the new good
is not included in the CPI for some years—until its price is already lower—
the CPI may miss counting this price decline altogether.
Taking these arguments together, the quality/new goods bias means that the

rise in the price of a fixed basket of goods over time tends to overstate the
rise in a consumer’s true cost of living because it does not take into account
how improvements in the quality of existing goods and the invention of new
goods improve the standard of living.
[Hide explanation.]
When the US Bureau of Labor Statistics, BLS, calculates the Consumer Price
Index, its first task is to decide on a basket of goods that is representative of
the purchases of the average household. This is done by using the Consumer
Expenditure Survey, a national survey of about 7,000 households that
provides detailed information on spending habits. Consumer expenditures are
broken up into eight major groups, shown below, which in turn are broken up
into more than 200 individual item categories. The BLS currently uses 1982–
1984 as the base period.
For each of these 200 individual expenditure items, the BLS chooses several
hundred very specific examples of that item and looks at the prices of those
examples. So, in figuring out the breakfast cereal item under the overall
category of foods and beverages, the BLS picks several hundred examples of
breakfast cereal. One example might be the price of a 24-oz. box of a
Cheerios brand cereal sold at a Walmart. The specific products and sizes and
stores chosen are statistically selected to reflect what people buy and where
they shop. The basket of goods in the CPI thus consists of about 80,000
products—several hundred specific products in over 200 broad-item
categories. About one quarter of these 80,000 specific products are rotated
out of the sample each year and replaced with a different set of products.
The next step is to collect data on prices. Data collectors visit or call about
23,000 stores in 87 urban areas all over the United States every month to
collect prices on these 80,000 specific products. A survey of 50,000 landlords
or tenants is also carried out to collect information about rents.
The CPI is then calculated by taking the 80,000 prices of individual products
and combining them—using weights determined by the quantities of these
products that people buy and allowing for factors like substitution between
goods and quality improvements—into price indices for the 200 or so overall
items. Then, the price indices for the 200 items are combined into an overall
CPI.
According to the Consumer Price Index website, these are the eight
categories used by data collectors:
 Food and beverages

 Housing
 Apparel
 Transportation
 Medical care
 Recreation
 Education and communication
 Other goods and services
This pie chart shows the relative size of each of the eight categories used to
generate the Consumer Price Index. The categories in order of highest to
lowest percentage of CPI are: housing, transportation, food and beverage,
medical care, education and communication, recreation, apparel, and other
goods and services.
Image credit: Figure 1 in "How Changes in the Cost of Living Are Measured" by OpenStaxCollege, CC BY
4.0
The Consumer Price Index and core inflation
index
Imagine you're driving a company truck across the country—you probably
would care about things like the prices of available roadside food and motel
rooms as well as the truck’s operating condition. However, the manager of
the firm might have different priorities. They would care mostly about the
truck’s on-time performance and much less about the driver's food and motel.
In other words, the company manager would be paying attention to the
production of the firm, while ignoring transitory elements that impact the
driver but don't affect the company’s bottom line.
In a sense, a similar situation occurs with regard to measures of inflation. As

we’ve learned, CPI measures prices as they affect everyday household
spending. The core inflation index is a little different—it is typically
calculated by taking the CPI and excluding volatile economic variables. In
this way, economists have a better sense of the underlying trends in prices
that affect the cost of living.
Examples of excluded variables include energy and food prices, which can
jump around from month to month because of the weather. According to an
article by Kent Bernhard, during Hurricane Katrina in 2005, a key supply
point for the nation’s gasoline was nearly knocked out. Gas prices quickly
shot up across the nation, in some places up to 40 cents a gallon in one day.
This was not caused by economic policy but was the result of a a short-lived
event. In this case, the CPI that month would register the change as a cost of
living event to households, but the core inflation index would remain
unchanged. As a result, the Federal Reserve’s decisions on interest rates
would not be influenced. Similarly, droughts can cause worldwide spikes in
food prices that, if temporary, do not affect the nation’s economic capability.
As former Chairman of the Federal Reserve Ben Bernanke noted in 1999
about the core inflation index, “It provide(s) a better guide to monetary policy
than the other indices, since it measures the more persistent underlying
inflation rather than transitory influences on the price level.” Bernanke also
noted that the core inflation index helps communicate that every inflationary
shock need not be responded to by the Federal Reserve since some price
changes are transitory and not part of a structural change in the economy.
In sum, both the CPI and the core inflation index are important, but they
serve different audiences. The CPI helps households understand their overall
cost of living from month to month, while the core inflation index is the
preferred gauge by which to make important government policy changes.
Practical solutions for substitution and

quality/new goods biases
By the early 2000s, the BLS was using alternative mathematical methods for
calculating the Consumer Price Index that were more complicated than just
adding up the cost of a fixed basket of goods in order to allow for some
substitution between goods. The BLS was also updating the basket of goods
behind the CPI more frequently so that new and improved goods could be
included more rapidly.
For certain products, the BLS was carrying out studies to try to measure the
quality improvement. For example, with computers, an economic study can
try to adjust for changes in speed, memory, screen size, and other
characteristics of the product and then calculate the change in price after
these product changes are taken into account. But these adjustments are
inevitably imperfect, and exactly how to make these adjustments is often a
source of controversy among professional economists.
By the early 2000s, the substitution bias and quality/new goods bias had been
somewhat reduced. Since then, the rise in the CPI probably overstates the
true rise in inflation by only about 0.5% per year. Over one or a few years,
this is not much; over a period of a decade or two, though, even half of a
percent per year compounds to a more significant amount. In addition, the
CPI tracks prices from physical locations and not from online sites like
Amazon, where prices can be lower.
When measuring inflation—and other economic statistics, too—a tradeoff

arises between simplicity and interpretation. If the inflation rate is calculated
with a basket of goods that is fixed and unchanging, then the calculation of
the inflation rate is straightforward, but the problems of substitution bias and
quality/new goods bias arise. However, when the basket of goods is allowed
to shift and evolve to reflect substitution toward lower relative prices, quality
improvements, and new goods, the technical details of calculating the
inflation rate grow more complex.
Additional price indices

The basket of goods behind the Consumer Price Index represents an average
hypothetical US household, which is to say that it does not exactly capture
anyone’s personal experience. When the task is to calculate an average level
of inflation, this approach works fine. What if, however, you are concerned
about inflation experienced by a certain group, like elderly people, people
living in poverty, single-parent families with children, or Latino people? In
specific situations, a price index based on the buying power of the average
consumer may not feel quite right.
This problem has a straightforward solution. If the CPI does not serve the
desired purpose, then invent another index, based on a basket of goods
appropriate for the group of interest. Indeed, the BLS publishes a number of
experimental price indices—some for particular groups like people living in
poverty, some for different geographic areas, and some for certain broad
categories of goods like food or housing.
The BLS also calculates several price indices that are not based on baskets of
consumer goods. For example, the Producer Price Index, or PPI, is based on
prices paid for supplies and inputs by producers of goods and services. It can
be broken down into price indices for different industries, commodities, and
stages of processing—like finished goods, intermediate goods, and crude
materials for further processing.
There is an International Price Index based on the prices of merchandise that

is exported or imported. An Employment Cost Index measures wage inflation
in the labor market. The GDP deflator—measured by the Bureau of
Economic Analysis—is a price index that includes all the components of
GDP. MIT's Billion Prices Project is a more recent alternative attempt to
measure prices: data are collected online from retailers and then composed
into an index that is compared to the CPI.
What’s the best measure of inflation? If you're concerned with the most
accurate measure of inflation, use the GDP deflator since it picks up the
prices of goods and services produced. Remember, though, that the GDP
deflator is not a good measure of cost of living as it includes prices of many
products not purchased by households—aircraft, fire engines, factory
buildings, office complexes, and bulldozers, among others.
If you want the most accurate measure of inflation as it impacts households,
use the CPI since it only picks up prices of products purchased by households
—which is why the CPI is sometimes referred to as the cost-of-living index.
As the BLS states on its website: “The ‘best’ measure of inflation for a given
application depends on the intended use of the data.”
Summary
 The Consumer Price Index, or CPI is a measure of inflation calculated
by US government statisticians based on the price level from a fixed basket
of goods and services that represents the purchases of the average consumer.
 The core inflation index is a measure of inflation typically calculated

by taking the CPI and excluding volatile economic variables such as food and
energy prices to better measure the underlying and persistent trend in long-
term prices.
 The quality/new goods bias causes inflation calculated using a fixed

basket of goods over time to overstate the true rise in cost of living because
improvements in the quality of existing goods and the invention of new
goods are not taken into account.
 The substitution bias causes an inflation rate calculated using a fixed

basket of goods over time to overstate the true rise in the cost of living
because it does not take into account that people can substitute away from
goods whose prices rise disproportionately.
 Several price indices are not based on baskets of consumer goods. The
GDP deflator is based on all the components of GDP. The Producer Price
Index is based on prices of supplies and inputs bought by producers of goods
and services. The Employment Cost Index measures wage inflation in the
labor market. The International Price Index is based on the prices of
merchandise that is exported or imported.
Which of the price indices introduced in this article would be most useful for
adjusting your paycheck for inflation?
[Hide solution.]
Since the CPI measures the prices of the goods and services purchased by the
typical urban consumer, it measures the prices of things that people buy with
their paycheck. For that reason, the CPI would be the best price index to use
for this purpose.
The Consumer Price Index is subject to substitution bias and quality/new

goods bias. Are the Producer Price Index and the GDP Deflator also subject
to these biases? Why or why not?
[Hide solution.]
The PPI is subject to these biases for essentially the same reasons the CPI is.
The GDP deflator picks up prices of what is actually purchased during a year,
so there are no biases. That is the advantage of using the GDP deflator over
the CPI.
Review questions
 Why does substitution bias arise if the inflation rate is calculated based
on a fixed basket of goods?
 Why does the quality/new goods bias arise if the inflation rate is
calculated based on a fixed basket of goods?
Critical-thinking questions
 Given the federal budget deficit in recent years, some economists have
argued that by adjusting Social Security payments for inflation using the CPI,
Social Security is overpaying recipients. What is the argument being made,
and do you agree or disagree with it?
 Why is the GDP deflator not an accurate measure of inflation as it

impacts a household?
 Imagine that the government statisticians who calculate the inflation

rate have been updating the basic basket of goods once every 10 years, but
now they decide to update it every five years. How will this change affect the
amount of substitution bias and quality/new goods bias?
The confusion over inflation
Key points
 Unexpected inflation tends to hurt those whose money received—in
terms of wages and interest payments—does not rise with inflation.
 Inflation can help those who owe money that can be paid back in less
valuable, inflated dollars.
 Low rates of inflation have relatively little economic impact over the
short term. Over the medium and the long term, however, even low rates of
inflation can complicate future planning.
 High rates of inflation can muddle price signals in the short term and
prevent market forces from operating efficiently.
The confusion over inflation
Many economists oppose high inflation, but they tend to oppose it with less
fervor than many non-economists.
Robert Shiller, one of 2013’s Nobel Prize winners in economics, carried out
several surveys during the 1990s about attitudes toward inflation. One of his
questions was “Do you agree that preventing high inflation is an important
national priority, as important as preventing drug abuse or preventing
deterioration in the quality of our schools?” Answers were on a scale of one
to five, where one meant “fully agree” and five meant “completely disagree.”
Of the entire US population, 52% answered “fully agree” that preventing

high inflation was a highly important national priority and just 4% answered
“completely disagree.” However, among professional economists, only 18%
answered “fully agree;” another 18% answered “completely disagree.”
The land of funny money

What are the economic problems caused by inflation, and why do economists
often regard them with less concern than the general public? Let's start with a
very short story: The Land of Funny Money.
One morning, everyone in the Land of Funny Money awakened to find that
the monetary value of everything had increased by 20%. The change was
completely unexpected. Every price in every store was 20% higher.
Paychecks were 20% higher. Interest rates were 20% higher. The amount of
money—everywhere from wallets to savings accounts—was 20% larger. This
overnight inflation of prices made newspaper headlines everywhere in the
Land of Funny Money. But the headlines quickly disappeared as people
realized that, in terms of what they could actually buy with their incomes, this
inflation had no economic impact. Everyone’s pay could still buy exactly the
same set of goods as it did before. Everyone’s savings were still sufficient to
buy exactly the same car, vacation, or retirement that they could have bought
before. Equal levels of inflation in all wages and prices ended up not
mattering much at all.
When the people in Robert Shiller’s surveys explained their concern about
inflation, one typical reason for their worry was that they feared that as prices
rose, they would not be able to afford to buy as much. In other words, people
were worried because they did not live in a place like the Land of Funny
Money, where all prices and wages rose simultaneously. Instead, people live
here on Earth, where prices might rise while wages do not rise at all, or where
wages rise more slowly than prices.
Economists note that over most periods, the inflation level in prices is
roughly similar to the inflation level in wages, so they reason that, on average
over time, people’s economic status is not greatly changed by inflation. If all
prices, wages, and interest rates adjusted automatically and immediately with
inflation, as in the Land of Funny Money, then no one’s purchasing power,
profits, or real loan payments would change. However, if other economic
variables do not move exactly in sync with inflation, or if they adjust for
inflation only after a time lag, then inflation can cause three types of
problems: unintended redistributions of purchasing power, blurred price
signals, and difficulties in long-term planning.
Unintended redistributions of purchasing power

Inflation can cause redistributions of purchasing power that hurt some and
help others. People who are hurt by inflation include those who are holding a
lot of cash, whether it is in a safe deposit box or in a cardboard box under the
bed. When inflation happens, the buying power of cash is diminished. But
cash is only an example of a more general problem: anyone who has financial
assets invested in a way that the nominal return does not keep up with
inflation will tend to suffer from inflation. For example, if a person has
money in a bank account that pays 4% interest, but inflation rises to 5%, then
the real rate of return for the money invested in that bank account is negative
1%.
The problem of a good-looking nominal interest rate being transformed into

an ugly-looking real interest rate can be worsened by taxes. The US income
tax is charged on the nominal interest received in dollar terms, without an
adjustment for inflation. So, a person who invests $10,000 and receives a 5%
nominal rate of interest is taxed on the $500 received—no matter whether the
inflation rate is 0%, 5%, or 10%. If inflation is 0%, then the real interest rate
is 5% and all $500 is a gain in buying power. But if inflation is 5%, then the
real interest rate is zero and the person had no real gain—but they owe
income tax on the nominal gain anyway. If inflation is 10%, then the real
interest rate is negative 5%, and the person is actually falling behind in
buying power. But, they would still owe taxes on the $500 in nominal gains.
Inflation can cause unintended redistributions for wage earners, too. Wages
do typically creep up with inflation over time—eventually. However,
increases in wages may lag behind inflation for a year or two since wage
adjustments are often somewhat sticky and occur only once or twice a year.
Also, the extent to which wages keep up with inflation creates insecurity for
workers and may involve painful, prolonged conflicts between employers and
employees. If the minimum wage is adjusted for inflation only infrequently,
minimum wage workers are losing purchasing power from their nominal
wages, as shown in the graph below.
US minimum wage and inflation
The graph shows that nominal minimum wages have increase substantially
since the 1970s. However, with the inflation adjustment, the minimum wage
has actually decreased in comparison to the 1970s.
Image credit: Figure 1 in "The Confusion Over Inflation " by OpenStaxCollege, CC BY 4.0
One sizable group of people has often received a large share of their income
in a form that does not increase over time—retirees who receive a private
company pension. Most pensions have traditionally been set as a fixed
nominal dollar amount per year at retirement. For this reason, pensions are
called defined-benefits plans. Even if inflation is low, the combination of
inflation and a fixed income can create a substantial problem over time. A
person who retires on a fixed income at age 65 will find that losing just 1% to
2% of buying power per year to inflation compounds to a considerable loss of
buying power after a decade or two.
Fortunately, pensions and other defined benefits retirement plans are

increasingly rare, replaced instead by “defined contribution” plans, such as
401(k)s and 403(b)s. In these plans, the employer contributes a fixed amount
to the worker’s retirement account on a regular basis, usually every pay
check. The employee often contributes as well. The worker invests these
funds in a wide range of investment vehicles. These plans are tax deferred,
and they are portable so that if the individual takes a job with a different
employer, their 401(k) comes with them. To the extent that the investments
made generate real rates of return, retirees do not suffer from the inflation
costs of traditional pensioners.
Ordinary people can sometimes benefit from the unintended redistributions of

inflation as well. Consider someone who borrows $10,000 to buy a car at a
fixed interest rate of 9%. If inflation is 3% at the time the loan is made, then
the loan must be repaid at a real interest rate of 6%. But if inflation rises to
9%, then the real interest rate on the loan is zero. In this case, the borrower’s
benefit from inflation is the lender’s loss. A borrower paying a fixed interest
rate who benefits from inflation is just the flip side of an investor receiving a
fixed interest rate who suffers from inflation. The lesson is that when interest
rates are fixed, rises in the rate of inflation tend to penalize suppliers of
financial capital, who end up being repaid in dollars that are worth less
because of inflation. At the same time, demanders of financial capital end up
better off because they can repay their loans in dollars that are worth less than
originally expected.
The unintended redistributions of buying power caused by inflation may have
a broader effect on society as well. The United States' widespread acceptance
of market forces rests on a perception that people’s actions have a reasonable
connection to market outcomes. When inflation causes a retiree who built up
a pension or invested at a fixed interest rate to suffer while someone who
borrowed at a fixed interest rate benefits from inflation, it is hard to believe
that this outcome was deserved in any way. Similarly, when homeowners
benefit from inflation because the price of their homes rises, while renters
suffer because they are paying higher rent, it is hard to see any useful
incentive effects. One of the reasons that inflation is so disliked by the
general public is a sense that it makes economic rewards and penalties more
arbitrary and therefore likely to be perceived as unfair—even dangerous..
[Hide explanation.]
Germany suffered an intense hyperinflation of its currency—the Mark—in

the years after World War I. The Weimar Republic in Germany resorted to
printing money to pay its bills and the onset of the Great Depression created
the social turmoil that Adolf Hitler took advantage of in his rise to power.
Robert Shiller described the connection this way in a National Bureau of
Economic Research 1996 Working Paper:
"A fact that is probably little known to young people today, even in
Germany, is that the final collapse of the Mark in 1923, the time when the
Mark’s inflation reached astronomical levels (inflation of 35,974.9% in
November 1923 alone, for an annual rate that month of 4.69 × 1028%), came
in the same month as did Hitler’s Beer Hall Putsch, his Nazi Party’s armed
attempt to overthrow the German government. This failed putsch resulted in
Hitler’s imprisonment, at which time he wrote his book Mein Kampf, setting
forth an inspirational plan for Germany’s future, suggesting plans for world
domination. . . . Most people in Germany today probably do not clearly
remember these events; this lack of attention to it may be because its memory
is blurred by the more dramatic events that succeeded it (the Nazi seizure of
power and World War II). However, to someone living through these
historical events in sequence . . . [the putsch] may have been remembered as
vivid evidence of the potential effects of inflation."
Blurred price signals

Prices are the messengers in a market economy; they convey information
about conditions of demand and supply. Inflation blurs those price messages.
Inflation means that price signals are perceived more vaguely, like a radio
program received with a lot of static. If the static becomes severe, it is hard to
tell what is happening.
In Israel, when inflation accelerated to an annual rate of 500% in 1985, some

stores stopped posting prices directly on items since they would have had to
put new labels on the items or shelves every few days to reflect inflation.
Instead, a shopper just took items from a shelf and went up to the checkout
register to find out the price for that day. Obviously, this situation makes
comparing prices and shopping for the best deal rather difficult.
When the levels and changes of prices become uncertain, businesses and
individuals find it harder to react to economic signals. In a world where
inflation is at a high rate, but bouncing up and down to some extent, does a
higher price of a good mean that inflation has risen, or that supply of that
good has decreased, or that demand for that good has increased? Should a
buyer of the good take the higher prices as an economic hint to start
substituting other products—or have the prices of the substitutes risen by an
equal amount? Should a seller of the good take a higher price as a reason to
increase production—or is the higher price only a sign of a general inflation
due to which the prices of all inputs to production are rising as well? The true
story will presumably become clear over time, but at a given moment, who
can say?
High and variable inflation means that the incentives in the economy to
adjust in response to changes in prices are weaker. Markets will adjust toward
their equilibrium prices and quantities more erratically and slowly, and many
individual markets will experience a greater chance of surpluses and
shortages.
Problems of long-term planning

Inflation can make long-term planning difficult. In the section above on
unintended redistributions, we discussed the case of someone trying to plan
for retirement with a pension that is fixed in nominal terms during a period of
a high inflation. Similar problems arise for all people trying to save for
retirement because they must consider what their money will really buy
several decades in the future when the rate of future inflation cannot be
known with certainty.
Inflation, especially at moderate or high levels, poses substantial planning

problems for businesses, too. A firm can make money from inflation—for
example, by paying bills and wages as late as possible so that it can pay in
inflated dollars, while collecting revenues as soon as possible. A firm can
also suffer losses from inflation, as in the case of a retail business that gets
stuck holding too much cash only to see the value of that cash eroded by
inflation. But when a business spends its time focusing on how to profit by
inflation, or at least how to avoid suffering from it, an inevitable tradeoff
strikes: less time is spent on improving products and services or on figuring
out how to make existing products and services more cheaply. An economy
with high inflation rewards businesses that have found clever ways of
profiting from inflation, which are not necessarily the businesses that excel at
productivity, innovation, or quality of service.
In the short term, low or moderate levels of inflation may not pose an
overwhelming difficulty for business planning because costs of doing
business and sales revenues may rise at similar rates. If, however, inflation
varies substantially over the short or medium term, then it may make sense
for businesses to stick to shorter-term strategies. The evidence as to whether
relatively low rates of inflation reduce productivity is controversial among
economists. There is some evidence that if inflation can be held to moderate
levels of less than 3% per year, it need not prevent a nation’s real economy
from growing at a healthy pace.
For some countries that have experienced hyperinflation of several thousand

percent per year, an annual inflation rate of 20–30% may feel basically the
same as zero. However, several economists have pointed to the suggestive
fact that when US inflation heated up in the early 1970s—to 10%—US
growth in productivity slowed down, and when inflation slowed down in the
1980s, productivity edged up again not long thereafter, as shown in the graph
below.
US inflation rate and US labor productivity, 1961–2014

This graph shows the trends in the inflation rate and US labor productivity
from the year 1961 to 2014. In 1961, the graph starts out at 1.5 for inflation
rate, remains steady around that rate until 1966, then increases to three. It
jumps to 11.4 in 1974 and ends up at 1.6 in 2014. In 1961, the graph starts out
at 0.8 for labor productivity, jumps to close to 4.5 in 1962, goes up and down,
and then ends up at zero in 2014.
Image credit: Figure 1 in "The Confusion Over Inflation " by OpenStaxCollege, CC BY 4.0
Any benefits of inflation?

Although the economic effects of inflation are primarily negative, two
counterbalancing points are worth noting. First, the impact of inflation differs
considerably according to whether it is creeping up slowly at 0% to 2% per
year, galloping along at 10% to 20% per year, or racing to the point of
hyperinflation at, say, 40% per month. Hyperinflation can rip an economy
and a society apart. An annual inflation rate of 2%, 3%, or 4%, however, is a
long way from a national crisis. Low inflation is also better than deflation
which occurs with severe recessions.
Second, an argument is sometimes made that moderate inflation may help the
economy by making wages in labor markets more flexible. A little inflation
can nibble away at real wages, and thus help real wages to decline if
necessary. In this way, even if a moderate or high rate of inflation may act as
sand in the gears of the economy, perhaps a low rate of inflation serves as oil
for the gears of the labor market. This argument is controversial. A full
analysis would have to take all the effects of inflation into account. It does,
however, offer another reason to believe that, all things considered, very low
rates of inflation may not be especially harmful.
Summary
 Unexpected inflation tends to hurt those whose money received—in
terms of wages and interest payments—does not rise with inflation.
 Inflation can help those who owe money that can be paid back in less
valuable, inflated dollars.
 Low rates of inflation have relatively little economic impact over the
short term. Over the medium and the long term, however, even low rates of
inflation can complicate future planning.
 High rates of inflation can muddle price signals in the short term and
prevent market forces from operating efficiently.
Self-check question
If inflation rises unexpectedly by 5%, would a state government that had
recently borrowed money to pay for a new highway benefit or lose?
[Hide solution.]
The state government would benefit because it would repay the loan in less
valuable dollars than it borrowed. Plus, tax revenues for the state government
would increase because of the inflation.
Review question
Identify several parties likely to be helped and several parties likely to be hurt
by inflation.
Critical-thinking questions
 If, over time, wages and salaries on average rise at least as fast as
inflation, why do people worry about how inflation affects incomes?
 Who in an economy is the big winner from inflation?

Lesson summary: Price indices and inflation
Lesson overview
You just got a raise! But wait: was that raise really a raise? The third of our
three key macroeconomic indicators, the inflation rate, can help you figure
that out. Inflation is an increase in the overall price level. The official
inflation rate is tracked by calculating changes in a measure called
the consumer price index (CPI). The CPI tracks changes in the cost of
living over time. Like other economic measures it does a pretty good job of
this. But it does have some limitations, such as substitution bias, which can
overstate how much the cost of living really has changed.
Key Terms
Key Term Definition
a sustained increase in the overall price level in the
inflation economy, which reduces the purchasing power of a dollar
the pace at which the overall price level is increasing; this

is the percentage increase in the price level from one
inflation rate period to the next.
a sustained decrease in the overall price level in the

deflation economy; deflation occurs if the inflation rate is negative.
a slowing of the rate of inflation; for example if the rate

of inflation is 5\%5%5, percent in 2016 and 3\%3%3,
percent in 2017, there is still inflation in 2017.Prices are
disinflation just not rising as fast as they were before.
a single number that summarizes all prices in an

aggregate economy; price indices are frequently used to represent
price level the aggregate price level.
a measure that calculates the changing cost of purchasing

a particular (and unchanging) combination of goods
(called a “market basket”) each year; the consumer price
price index index and the producer price index are examples.
consumer an index that calculates the cost of a market basket of

Key Term Definition
goods purchased by a typical family that lives in an urban
price index area; the purpose of the CPI is to track changes in the cost
(CPI) of living over time.
market the combination of goods that are used to calculate a price

basket index; the goods stay the same from year to year.
a reference year to which variables are compared; for

example, the current CPI in the United States uses 1983
as its base year, so all values of the CPI compare the
base year current to 1983.
variables that are adjusted for the rate of inflation that

represent the true value of something (such as real
interest, real income, or real GDP); for example if your
boss gives you a 10\%10%10, percent raise, but the
purchasing power of your money has decreased
by 8\%8%8, percent because of inflation, your raise is
real variables really only worth 2\%2%2, percent.
variables such as wages, income, or interest that have not

been adjusted for the rate of inflation; you can think of
nominal variables as the “sticker price.” The bank tells
you they will pay you 3\%3%3, percent interest, but the
nominal real interest rate that tells you what you are actually
variables earning.
purchasing what can actually be bought with money; if you walk into
power a store with \$10$10dollar sign, 10 and want to buy
apples that cost \$1$1dollar sign, 1 each, the purchasing
Key Term Definition
power of your \$10$10dollar sign, 10 is 101010 apples;
If the next day the price of apples increases to \
$2$2dollar sign, 2, you can only buy 555 apples, so the
purchasing power of your \$10$10dollar sign, 10 has
decreased.
the interest rate earned that reflects the actual purchasing

power of that interest; for example if a bank
pays 3\%3%3, percent interest, but there is 2\%2%2,
percent inflation, you really have only gained 1\%1%1,
real interest percentinterest because the purchasing power of your
rate interest has decreased.
Key takeaways
The Consumer Price Index (CPI)

The Consumer Price Index (CPI) measures the change in income a consumer
needs to maintain the same standard of living over time. The CPI is meant to
reflect changes in the cost of living for a typical urban household.
For example, suppose every household buys 222 bottles of cod liver

oil, 101010 loaves of bread, and 888 dog treats every week. A consumer
price index tracks changes in the price of this unchanging collection of goods
over time to measure changes in the cost of living for this household. Once
the CPI is calculated for two years, we can to calculate the rate of inflation.
How the CPI is calculated

Let’s use the example above of the “basket of goods” consisting of 2 bottles
of cod liver oil, 10 loaves of bread, and 8 dog food treats. Once the prices of
the goods are calculated, the price of the basket in that year is compared to
the price of the basket in some base year.
[Thanks!]
Let’s take that basket of goods our example family buys every week. Suppose
that 1995 is the base year. We want to calculate the CPI for 2016.
To calculate the consumer price index we 1) calculate the price of the basket
in the base year, 2) then the price of the basket in the year we want the CPI
for, then finally 3) apply this formula:
CPI = \dfrac{\text{Price of goods in 2016}}{\text{Price of goods in

1995}} \times 100CPI=Price of goods in 1995Price of goods in 2016×100C,
P, I, equals, start fraction, start text, P, r, i, c, e, space, o, f, space, g, o, o, d, s,
space, i, n, space, 2016, end text, divided by, start text, P, r, i, c, e, space, o, f,
space, g, o, o, d, s, space, i, n, space, 1995, end text, end fraction, times, 100.
We collect the prices that these goods sold for in 1995 and 2016, as shown in
the table below:
Quantit
Price of Quantit Price of a Quantit Price of y of
Yea cod liver y of cod loaf of y of doggy doggy
r oil liver bread bread treats treats
\ \ \
199 $5$5dolla $1$1dolla $2$2dolla
5 r sign, 5 222 r sign, 1 101010 r sign, 2 888
201 \ 222 \ 101010 \ 888

6 $7$7dolla $2$2dolla $4$4dolla
Quantit
Price of Quantit Price of a Quantit Price of y of
Yea cod liver y of cod loaf of y of doggy doggy
r oil liver bread bread treats treats
r sign, 7 r sign, 2 r sign, 4
Using our prices to calculate the CPI in the base year (1995) and the year for
which we want to calculate the CPI (2016):
\begin{aligned}\text{Price of bundle in 1995}&=(\$5\times2) + (\

$1\times10) + (\$2\times8)\\ &= \$36\\ \\ \text{Price of bundle in 2016}&= (\
$7\times2) + (\$2\times 10) + (\$4\times8) \\&= \
$66\end{aligned}Price of bundle in 1995Price of bundle in 2016=($5×2)+
($1×10)+($2×8)=$36=($7×2)+($2×10)+($4×8)=$66
CPI is then calculated as: \begin{aligned}\text{CPI} & = \dfrac{\$66}{\

$36}\times100\\ \\ &=183\end{aligned}CPI=$36$66×100=183
How the CPI is used to calculate the rate of inflation

The inflation rate is determined by calculating the percentage change in a
price index (such as CPI or the GDP deflator). The inflation rate tells us the
percentage by which the price level is changing from period to period.
[Thanks!]
To calculate the rate of inflation, you implement this formula:
\text{inflation rate} = \dfrac{CPI_2-CPI_1}{CPI_1}\times

100\%inflation rate=CPI1CPI2−CPI1×100%start text, i, n, f, l, a, t, i, o, n,
space, r, a, t, e, end text, equals, start fraction, C, P, I, start subscript, 2, end
subscript, minus, C, P, I, start subscript, 1, end subscript, divided by, C, P, I,
start subscript, 1, end subscript, end fraction, times, 100, percent
Think of this formula this way—any rate of change (such as the rate of
change of prices, which is what the inflation rate is measuring) can be
calculated as: “new minus old, over old”:
\text{Rate of change} = \dfrac{\text{new value}-\text{old value}}{\text{old

value}} \times 100\%Rate of change=old valuenew value−old value
×100%start text, R, a, t, e, space, o, f, space, c, h, a, n, g, e, end text, equals,
start fraction, start text, n, e, w, space, v, a, l, u, e, end text, minus, start text,
o, l, d, space, v, a, l, u, e, end text, divided by, start text, o, l, d, space, v, a, l,
u, e, end text, end fraction, times, 100, percent.
Suppose that you had previously calculated that the CPI in 2015 is 175 and
the CPI in 2016 is 183. We calculate the rate of inflation between 2015 and
2016 as
\begin{aligned} \text{Rate of inflation} &= \dfrac{183-175}{175}\\\\ & =

4.57\%\end{aligned}Rate of inflation=175183−175=4.57%
Adjusting nominal variables into real variables

Real variables are nominal variables deflated by the price level. Examples of
real variables are a real wage or a real interest rate. For instance, the sign at
the bank says that they are paying 8\%8%8, percent interest, but what are
really earning?
If we want to find the real interest rate (the one that reflects what people are
actually earning on money deposited in the bank), then we want to take away
the effect of inflation. We do so because inflation reduces the purchasing
power of the money deposited.
If the interest rate the bank gives us (the nominal interest rate) is 8\%8%8,
percent, but the rate of inflation is 5\%5%5, percent, we are really
earning 8\%-5\%=3\%8%−5%=3%8, percent, minus, 5, percent, equals, 3,
percent on the money that we put in the bank. Why? Because that is how
much more we can buy when we take our money out after a year.
[Thanks!]
Let’s apply this approach to adjusting nominal wages to real wages. Nominal
wages are what your contract says you make, but real wages are what you
actually can do with that money.
Suppose your mom made a salary of $50,000 in 2010 and $55,000 in 2015.
On the surface, it looks like she is earning more than she used to. But is she
really? That depends on whether the purchasing power of her earnings has
stayed the same.
Let's say we know that the GDP deflator for 2010 is 1.20 and the GDP
deflator for 2015 is 1.40. We can use these values to deflate the salaries in
each year to their real purchasing power and then compare them:
\begin{aligned} \text{Real earnings in 2010} &= \dfrac{\$50,000}{1.20}\\ \\

&=\$41,666.67\\ \\ \text{Real earnings in 2015} &=\dfrac{\$55,000}
{1.40}\\ \\ &=\
$39,285.71\end{aligned}Real earnings in 2010Real earnings in 2015
=1.20$50,000=$41,666.67=1.40$55,000=$39,285.71
As it turns out, in real terms, you mom’s salary has actually decreased! Uh
oh!
The shortcomings of CPI as a measure of the cost of

living
Using the CPI as a measure of inflation has some shortcomings. That can
cause the CPI to overstate the true inflation rate. For example,
substitution bias
causes the CPI to overstate increases in the cost of living. When the prices of
goods go up, people will substitute other similar goods in place of the good
that is now more expensive. But because the CPI assumes that the basket of
goods never changes, it makes it appear that people always buy the same
amount of a good that is now more expensive.
Another shortcoming of CPI is that it fails to account for changes in quality.

For example, one of the reasons a 2013 Volvo Station Wagon costs more
than a 1973 Volvo Station Wagon is that the newer model has things like
seatbelts in the backseat, FM radio, and air conditioning. The CPI, however,
treats these vehicles as identical, which overstates the true rate of inflation.
Key Equations
For any year, ttt:
\begin{aligned} CPI_t &=\dfrac{\text{Cost of basket in year }t}
{\text{Cost of basket base year}} \times100\\ \\ \text{Inflation
rate} &= \dfrac{CPI_{new}-CPI_{old}}{CPI_{old}} \times
100 \end{aligned}CPItInflation rate
=Cost of basket base yearCost of basket in year t×100=CPIold
CPInew−CPIold×100
Common Misperceptions
 If there is 2\%2%2, percent inflation every year for five years, then
after ten years the price level has gone up to 20\%20%20, percent, right?
No! Inflation compounds over time. For example, suppose a chicken coop
costs \$100$100dollar sign, 100 and there is 2\%2%2, percentinflation,
that means that after a year the chicken coop will cost \$102$102dollar
sign, 102. If inflation continues at 2\%2%2, percent for another year, the \
$102$102dollar sign, 102 grows by 2\%2%2, percent, not the original
price. In fact, if there is 2\%2%2, percent inflation every year for 10 years,
the chicken coop will cost \$121.90$121.90dollar sign, 121, point,
90, 21.9\%21.9%21, point, 9, percent more than the original price.
 The term “index” might sound strange, but an index is simply any
measure that compares a value in one period to the value in a base year.
 Another common misperception is that once we calculate the CPI, we
have the rate of inflation between any two years. That is a necessary step, but
it is not the final step. We must then use the CPI in both years to calculate the
rate of inflation.
 There are actually several different price indices used to calculate the
rate of inflation. The CPI is the one that is used to calculate the official rate of
inflation, which is why you’ll often hear it reported in the news.
Discussion Questions:
 What are some reasons that the CPI might not capture the true rate of
inflation?
 How might changes in spending habits of households over a 20 year

period change? How does this impact CPI as a measure of the cost of living?
 The CPI in the nation of Montrose was 220 in 2016 and 200 in 2015.
What is the rate of inflation between 2015 and 2016?
[You got me. HELP!]
Lesson summary: The costs of inflation
Lesson overview
Inflation can get a bad rap. For instance, some people think inflation makes
everyone worse off. But it turns out that there are both winners and losers
from inflation. In general, if you owe money that has to be paid back with a
fixed amount of interest, you are going to benefit from unexpected inflation.
On the other hand, if someone owes you money, when there is unexpected
inflation the money you are paid back won’t be worth as much as the money
you loaned out.
Key Terms
Term Definition
when the price level increases at a faster pace than
unanticipated expected; for example, if you think that the rate of
inflation inflation will be 5%, but it turns out to be 8%.
when the price level increases at a slower pace than

unanticipated anticipated; for example, if you think the rate of
disinflation inflation will be 5%, but it turns out to be 2%.
when the price level decreases when it was expected to

unanticipated increase; for example, if you think the rate of inflation
deflation will be 2%, but it turns out to be -2%.
when the real value of wealth is transferred from one

agent to another; when inflation is higher than
wealth borrowers and lenders expected, wealth is transferred
redistribution from lenders to borrowers.
lender an agent (usually a bank) or a person (for example, a

holder of a bond) who makes money available to
Term Definition
another agent, with the agreement that the money will
be repaid (usually with interest)
an agent that has received money from another agent

with the agreement that the money will be repaid
borrower (usually with interest)
an agent that is not spending some of their income;

usually if money is saved it is put in some sort of
interest-earning asset (like a savings account or a bond)
or purchasing some other financial asset (such as stocks
saver and bonds).
an asset that is a promise to pay a fixed amount at some

point in the future; for example, the government sells
Tony a bond for \$100$100dollar sign, 100 with the
promise of paying him back \$104$104dollar sign,
104in one year, which allows Tony’s savings to earn
bond interest.
Key takeaways
The redistribution effect of inflation

Unexpected inflation arbitrarily redistributes wealth from one group to
another group, such as from borrowers to lenders. When people decide to
borrow money or lend money, they often consider what they think the rate of
inflation will be. When the rate of inflation is different than anticipated, the
amount of interest repaid or earned will also be different than what they
expected.
 Lenders are hurt by unanticipated inflation because the money they get
paid back has less purchasing power than the money they loaned out.
 Borrowers benefit from unanticipated inflation because the money they

pay back is worth less than the money they borrowed.
[Thanks!]
For example, suppose Jerry borrows \$10$10dollar sign, 10 from Michonne

and promises to pay her back \$11$11dollar sign, 11 next year. This year \
$1$1dollar sign, 1 can buy one can of tuna, so in Jerry’s mind, he is
promising to pay back 111111 cans of tuna next year in exchange for the
ability to buy 101010 cans this year. Suppose over the course of that year
there is inflation and the price of tuna doubles. This means that Jerry is
paying back the value of only 5.55.55, point, 5 cans of tuna, so he benefits
from this inflation. Michonne, on the other hand, is hurt because she thought
she was getting more cans of tuna in exchange for her loan.
The redistribution effects of disinflation and deflation

Unanticipated disinflation or deflation, when the inflation rate is lower than it
was expected to be (or even negative), has the opposite effect as
unanticipated inflation: lenders are helped and borrowers are hurt.
Lenders are helped by unanticipated disinflation or deflation because the

money they get paid back has more purchasing power than the money they
expected it to be when they loaned it out.
Borrowers are hurt by deflation in particular because they have to pay back
their debts with money worth more than the money they borrowed in the first
place!
Most policies that target inflation are aimed at maintaining small and
predictable rates of inflation. Inflation that is too close to zero runs the risk of
becoming negative, and deflation becomes a possibility. Deflation has a very
damaging impact on an economy and is associated with particularly severe
recessions and depressions. If you hear about policymakers talking about
"lowering inflation," their objective is slowing down the rate of inflation (in
other words, disinflation), not deflation.
 A common misperception is that inflation is bad for everyone (who
likes more expensive stuff?). But this is not the case. Inflation reduces the
value of money. Because of that, people who have borrowed money benefit
from a higher inflation rate when they pay the money back. The interest rate
that a borrower pays is effectively lower thanks to inflation.
 Another common misperception is that disinflation and deflation are

good for everyone (who doesn't enjoy cheaper stuff?). The problem is,
deflation increases the purchasing power of money. People who have
borrowed money are paying back that loan with money that is effectively
worth more than the money they borrowed. Deflation effectively increases
the interest rate that a borrower pays.
 A very common misperception is that inflation should always be

avoided. Deflation has such a destructive impact on an economy that most
policymakers agree that avoiding deflation is a far more important objective.
As a result, the goal of policymakers is not zero inflation, but small and
predictable inflation rates.
1) Suppose you take out a \$50{,}000$50,000dollar sign, 50, comma,
000 loan from the Bank of Baloney to pay for college, and they give you five
years to pay back the loan. If inflation unexpectedly increases over the next
five years, who is helped by the inflation, you or the bank?
[Thanks!]
The unexpected inflation benefits you and hurts the bank. The value of the
dollars you pay back to the bank is less than the value of the dollars the bank
thought they would be getting because you are paying back the loan using
dollars that are worth less.
2) The Lady of Wintersfell has borrowed \$2.5$2.5dollar sign, 2, point,

5 million dollars from the Iron Bank of Bravodos which she promises to pay
back in five years. During those five years there is unanticipated deflation
across the kingdom. How does this deflation redistribute wealth between the
borrowers and lenders? Explain.
[Thanks!]
Unanticipated deflation hurts the Lady of Wintersfell (the borrower) and

benefits the Iron Bank (the lender). The Lady of Wintersfell will see a
decrease in her wealth as she must pay back the Iron Bank with money that is
now worth more than she borrowed. The Iron Bank, on the other hand, will
see their wealth increase as a result of the unanticipated deflation.
3) You inherit a fortune of \$100$100dollar sign, 100, which you place in a

secure savings account that has a fixed interest rate. The inflation rate ends
up being higher than you anticipated when you first placed your money in the
bank. Does your expected wealth increase, decrease, or stay the same over
time? Explain.
[Thanks!]
The higher than anticipated inflation rate reduces your future wealth. Savers
with fixed interest rates are worse off when inflation is higher than expected
because effectively the value of interest income they earn is lower than what
they thought it would have been based on expected inflation rates.
Adjusting nominal values to real values
Key points
 The nominal value of any economic statistic is measured in terms of
actual prices that exist at the time.
 The real value refers to the same statistic after it has been adjusted for
inflation.
 To convert nominal economic data from several different years into

real, inflation-adjusted data, the starting point is to choose a base
yeararbitrarily and then use a price index to convert the measurements so that
they are measured in the money prevailing in the base year.
Introduction
When we examine economic statistics, it's crucial to distinguish between
nominal and real measurements so we know whether or not inflation has
distorted a given statistic.
Looking at economic statistics without considering inflation is like looking

through a pair of binoculars and trying to guess how close something is—
unless you know how strong the lenses are, you cannot guess the distance
very accurately. Similarly, if you do not know the rate of inflation, it is
difficult to figure out if a rise in gross domestic product, or GDP, is due
mainly to a rise in the overall level of prices or to a rise in quantities of goods
produced.
The nominal value of any economic statistic means the statistic is measured

in terms of actual prices that exist at the time. The real value refers to the
same statistic after it has been adjusted for inflation. Generally, it is the real
value that is more important.
Converting nominal GDP to real GDP

The table and graph below shows US GDP at five-year intervals since 1960
in nominal dollars, in other words, GDP measured using the actual market
prices prevailing in each stated year.
If an unwary analyst compared nominal GDP in 1960 to nominal GDP in

2010, it might appear that national output had risen by a factor of 27 over this
time—GDP of \$14,958$14,958dollar sign, 14, comma, 958 billion in 2010
divided by GDP of \$543$543dollar sign, 543 billion in 1960. This
conclusion would be highly misleading, though.
We need to figure out the change in real GDP from 1960 to 2010 to truly
understand how much the national output has risen.
Yea Nominal GDP in billions of

r dollars GDP deflator, 2005 = 100
1960 543.3 19.0
1965 743.7 20.3
1970 1,075.9 24.8
1975 1,688.9 34.1

Yea Nominal GDP in billions of
r dollars GDP deflator, 2005 = 100
1980 2,862.5 48.3
1985 4,346.7 62.3
1990 5,979.6 72.7
1995 7,664.0 81.7
2000 10,289.7 89.0
2005 13,095.4 100.0
2010 14,958.3 110.0

US nominal GDP and the GDP deflator
Source: www.bea.gov
The graph shows that nominal GDP has risen substantially since 1960 to a
high of \$14,527$14,527dollar sign, 14, comma, 527in 2010.
Image credit: Figure 1 in "Adjusting Nominal Values to Real Values" by OpenStaxCollege, CC BY 4.0
Remember, nominal GDP is defined as the quantity of every good or service
produced multiplied by the price at which it was sold, summed up for all
goods and services. In order to see how much production has actually
increased, we need to extract the effects of higher prices on nominal GDP.
We can do this using the GDP deflator.
The GDP deflator is a price index measuring the average prices of all goods
and services included in the economy. The data for the GDP deflator are
given in the table above and shown visually in the graph below.
[Hide explanation.]
When you read "2005=100" in the table, you know that 2005 is our base
year.
Whenever you compute a real statistic, one year—or period—plays a special

role. This year or period is called the base year or base period.
The base year is the year whose prices are used to compute the real statistic.
When we calculate real GDP, for example, we take the quantities of goods
and services produced in each year—for example, 1960 or 1973—and
multiply them by their prices in the base year—in this case, 2005—to get a
measure of GDP that uses prices that do not change from year to year. That is
why you'll see real GDP labeled “2005 dollars,” indicating that in this
instance real GDP is constructed using prices that existed in 2005.
The formula used to calculate the GDP deflator is below.
\text{GDP deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} ×

100GDP deflator=Real GDPNominal GDP×100start text, G, D, P, space, d, e, f, l, a,
t, o, r, end text, equals, start fraction, start text, N, o, m, i, n, a, l, space, G, D,
P, end text, divided by, start text, R, e, a, l, space, G, D, P, end text, end
fraction, ×, 100
Rearranging the formula and using the data from 2005, we get the following:
\text{Real GDP} = \frac{\text{Nominal GDP}}{\text{Price Index} /

100}Real GDP=Price Index/100Nominal GDPstart text, R, e, a, l, space, G, D, P, end
text, equals, start fraction, start text, N, o, m, i, n, a, l, space, G, D, P, end
text, divided by, start text, P, r, i, c, e, space, I, n, d, e, x, end text, slash, 100,
end fraction
\text{Real GDP} = \frac{\$13,095.4\text{ billion}}

{100/100}Real GDP=100/100$13,095.4 billionstart text, R, e, a, l, space, G, D, P,
end text, equals, start fraction, dollar sign, 13, comma, 095, point, 4, start
text, space, b, i, l, l, i, o, n, end text, divided by, 100, slash, 100, end fraction
\text{Real GDP} = \$13,095.4\text{ billion}Real GDP=$13,095.4 billionstart

text, R, e, a, l, space, G, D, P, end text, equals, dollar sign, 13, comma, 095,
point, 4, start text, space, b, i, l, l, i, o, n, end text
If you compare the real GDP you just calculated for 2005 and the nominal
GDP listed for 2005 in the table above, you'll see they are the same. This is
no accident. It is because 2005 has been chosen as the base year in this
example. Since the price index in the base year always has a value of 100—
by definition—nominal and real GDP are always the same in the base year.
Now let's take a look at the data for 2010.
\text{Real GDP} = \frac{\text{Nominal GDP}}{\text{Price Index} /

100}Real GDP=Price Index/100Nominal GDPstart text, R, e, a, l, space, G, D, P, end
text, equals, start fraction, start text, N, o, m, i, n, a, l, space, G, D, P, end
text, divided by, start text, P, r, i, c, e, space, I, n, d, e, x, end text, slash, 100,
end fraction
\text{Real GDP} = \frac{\$14,958.3\text{ billion}}

{110/100}Real GDP=110/100$14,958.3 billionstart text, R, e, a, l, space, G, D, P,
end text, equals, start fraction, dollar sign, 14, comma, 958, point, 3, start
text, space, b, i, l, l, i, o, n, end text, divided by, 110, slash, 100, end fraction
\text{Real GDP} = \$13,598.5\text{ billion}Real GDP=$13,598.5 billionstart

text, R, e, a, l, space, G, D, P, end text, equals, dollar sign, 13, comma, 598,
point, 5, start text, space, b, i, l, l, i, o, n, end text
We can use this new data to come to another conclusion—as long as inflation
is positive, meaning prices increase on average from year to year, real GDP
should be less than nominal GDP in any year after the base year.
This is because the value of nominal GDP is increased by inflation. Similarly,

as long as inflation is positive, real GDP should be greater than nominal GDP
in any year before the base year.
The graph shows that the U.S. GDP deflator has risen substantially since
1960.
The graph above shows that the price level has risen dramatically since 1960.
The price level in 2010 was almost six times higher than in 1960—the
deflator for 2010 was 110 versus a level of 19 in 1960. Based on this
information, we know that much of the apparent growth in nominal GDP was
due to inflation, not an actual change in the quantity of goods and services
produced—in other words, not in real GDP.
The graph below shows the US nominal and real GDP since 1960. Because
2005 is the base year, the nominal and real values are exactly the same in that
year. However, over time, the rise in nominal GDP looks much larger than
the rise in real GDP—the nominal GDP line rises more steeply than the real
GDP line—because the rise in nominal GDP is exaggerated by the presence
of inflation, especially in the 1970s.
The graph shows the relationship between real GDP and nominal GDP. After
2005, nominal GDP appears lower than real GDP because dollars became
worth less than they were in 2005.
Okay! Now to solve our problem! How much did the national output rise
between 1960 and 2010? In other words, what was the change in real GDP?
Nominal GDP can rise for two reasons: an increase in output and/or an
increase in prices. Knowing that, we can extract the increase in prices from
nominal GDP in order to measure only changes in output.
Step 1: Understand that nominal measurements are in

value terms.
\text{Value} = \text{Price} ×
\text{Quantity}Value=Price×Quantitystart text, V, a, l, u, e, end text,
equals, start text, P, r, i, c, e, end text, ×, start text, Q, u, a, n, t, i, t, y, end text
or
\text{Nominal GDP} = \text{GDP Deflator} × \text{Real
GDP}Nominal GDP=GDP Deflator×Real GDPstart text, N, o, m, i,
n, a, l, space, G, D, P, end text, equals, start text, G, D, P, space, D, e, f, l, a, t,
o, r, end text, ×, start text, R, e, a, l, space, G, D, P, end text
[Hide explanation.]
Let’s step aside for a minute and look at an example at the micro level to
better understand the concept. Suppose a t-shirt company, Coolshirts, sells 10
t-shirts at a price of $9 each. We can calculate Coolshirts' nominal revenue
from sales using the formula below:
\text{Nominal revenue from sales} = \text{Price} \times

\text{Quantity}Nominal revenue from sales=Price×Quantitystart text, N, o,
m, i, n, a, l, space, r, e, v, e, n, u, e, space, f, r, o, m, space, s, a, l, e, s, end
text, equals, start text, P, r, i, c, e, end text, times, start text, Q, u, a, n, t, i, t, y,
end text\text{Nominal revenue from sales} = \$9 ×
10Nominal revenue from sales=$9×10start text, N, o, m, i, n, a, l, space, r, e,
v, e, n, u, e, space, f, r, o, m, space, s, a, l, e, s, end text, equals, dollar sign, 9,
×, 10 \text{Nominal revenue from sales} = \
$90Nominal revenue from sales=$90start text, N, o, m, i, n, a, l, space, r, e, v,
e, n, u, e, space, f, r, o, m, space, s, a, l, e, s, end text, equals, dollar sign, 90
Next, let's calculate Coolshirts' real income.
\text{Real income} = \frac{\text{Nominal revenue}}

{\text{Price}}Real income=PriceNominal revenuestart text, R, e, a, l, space, i, n, c,
o, m, e, end text, equals, start fraction, start text, N, o, m, i, n, a, l, space, r, e,
v, e, n, u, e, end text, divided by, start text, P, r, i, c, e, end text, end fraction
\text{Real income} = \frac{\$90}{\$9}Real income=$9$90start text, R, e, a, l,

space, i, n, c, o, m, e, end text, equals, start fraction, dollar sign, 90, divided
by, dollar sign, 9, end fraction
\text{Real income} = 10Real income=10start text, R, e, a, l, space, i, n, c, o,

m, e, end text, equals, 10
In other words, when we compute real measurements we are trying to get at

actual quantities—in this case, 10 t-shirts.
Step 2: Calculate real GDP using the formula below.

\text{Real GDP} = \frac{\text{Nominal GDP}}{\text{Price
Index}}Real GDP=Price IndexNominal GDPstart text, R, e, a, l, space, G, D,
P, end text, equals, start fraction, start text, N, o, m, i, n, a, l, space, G, D, P,
end text, divided by, start text, P, r, i, c, e, space, I, n, d, e, x, end text, end
fraction
Mathematically, a price index is a two-digit decimal number like 1.00 or 0.85

or 1.25. But—because some people have trouble working with decimals—the
price index has traditionally been multiplied by 100 to get integer numbers
like 100, 85, or 125 when it's published. This means that when we deflate
nominal figures to get real figures—by dividing the nominal by the price
index—we also need to remember to divide the published price index by 100
to make the math work. So, we change our real GDP formula slightly:
Index} / 100}Real GDP=Price Index/100Nominal GDPstart text, R, e, a, l,
space, G, D, P, end text, equals, start fraction, start text, N, o, m, i, n, a, l,
space, G, D, P, end text, divided by, start text, P, r, i, c, e, space, I, n, d, e, x,
end text, slash, 100, end fraction
Step 3: Calculate rate of growth of real GDP from 1960

to 2010.
To find the real growth rate, we apply the formula for percentage change:
\dfrac{\text{2010 real GDP} – \text{1960 real GDP}}
{\text{1960 real GDP}} × 100 = \text{percent
change}1960 real GDP2010 real GDP–1960 real GDP
×100=percent changestart fraction, start text, 2010, space, r, e, a, l, space,
G, D, P, end text, –, start text, 1960, space, r, e, a, l, space, G, D, P, end text,
divided by, start text, 1960, space, r, e, a, l, space, G, D, P, end text, end
fraction, ×, 100, equals, start text, p, e, r, c, e, n, t, space, c, h, a, n, g, e, end
text
13,598.5 – 2,859.52,859.5 × 100 = 376%13,598.5–
2,859.52,859.5×100=37613, comma, 598, point, 5, –, 2, comma, 859,
point, 52, comma, 859, point, 5, ×, 100, equals, 376
In other words, the US economy has increased real production of goods and
services by 376%—nearly a factor of four—since 1960. Of course, that
understates the material improvement since it fails to capture improvements
in the quality of products and the invention of new products.
Try it on your own!
The table below contains all the data you need to compute real GDP.
Step 1. Pull necessary information from the table.

To compute real GPD for 1960, we need to know that in 1960 nominal GDP
was $543.3 billion and the price index, or GDP deflator, was 19.0.
Step 2. Calculate the real GDP in 1960.

\text{Real GDP} = \frac{\$543.3 \text{ billion}}{19 /

100}Real GDP=19/100$543.3 billionstart text, R, e, a, l, space, G, D, P, end text,
equals, start fraction, dollar sign, 543, point, 3, start text, space, b, i, l, l, i, o,
n, end text, divided by, 19, slash, 100, end fraction
\text{Real GDP} = \$2,859.5
\text{ billion}Real GDP=$2,859.5 billionstart text, R, e, a, l, space,
G, D, P, end text, equals, dollar sign, 2, comma, 859, point, 5, start text,
space, b, i, l, l, i, o, n, end text
[Hide explanation.]
Let's tackle this in two parts.
First adjust the price index, which is the bottom of the fraction in the formula:
19 divided by 100 is 0.19.
Then, divide .19 into the nominal GDP, $543.3 billion, to get $2,859.5
billion.
Step 3. Use the same formula to calculate the real GDP

in 1965.
\text{Real GDP} = \frac{\$743.7 \text{ billion}}{20.3 /
100}Real GDP=20.3/100$743.7 billionstart text, R, e, a, l, space, G, D, P, end
text, equals, start fraction, dollar sign, 743, point, 7, start text, space, b, i, l, l,
i, o, n, end text, divided by, 20, point, 3, slash, 100, end fraction
\text{Real GDP} = \$3,663.5
\text{ billion}Real GDP=$3,663.5 billionstart text, R, e, a, l, space,
G, D, P, end text, equals, dollar sign, 3, comma, 663, point, 5, start text,
space, b, i, l, l, i, o, n, end text
Step 4. Continue using this formula to calculate all of

the real GDP values from 1970 through 2010.
You can double check your answers by looking at the far-right column in the
table below.
Nominal GDP GDP Real GDP in
in billions of deflator, billions of
Year dollars 2005 = 100 Calculations 2005 dollars
543.3 /
1960 543.3 19.0 (19.0/100) 2859.5
743.7 /
1965 743.7 20.3 (20.3/100) 3663.5
1,075.9 /
1970 1075.9 24.8 (24.8/100) 4338.3
1,688.9 /
1975 1688.9 34.1 (34.1/100) 4952.8
2,862.5 /
1980 2862.5 48.3 (48.3/100) 5926.5
4,346.7 /
1985 4346.7 62.3 (62.3/100) 6977.0
5,979.6 /
1990 5979.6 72.7 (72.7/100) 8225.0
7,664 /
1995 7664.0 82.0 (82.0/100) 9346.3
10,289.7 /
2000 10289.7 89.0 (89.0/100) 11561.5
13,095.4 /
2005 13095.4 100.0 (100.0/100) 13095.4
2010 14958.3 110.0 14,958.3 / 13598.5

Nominal GDP GDP Real GDP in
in billions of deflator, billions of
Year dollars 2005 = 100 Calculations 2005 dollars
(110.0/100)
Converting nominal to real GDP
Source: Bureau of Economic Analysis, www.bea.gov
Summary
 The nominal value of any economic statistic is measured in terms of
actual prices that exist at the time.
 The real value refers to the same statistic after it has been adjusted for
inflation.
 To convert nominal economic data from several different years into

real, inflation-adjusted data, the starting point is to choose a base
yeararbitrarily and then use a price index to convert the measurements so that
they are measured in the money prevailing in the base year.
Self-check question
Based on data from the table in the Try it on your own! section, how much of
the nominal GDP growth from 1980 to 1990 was real GDP and how much
was inflation?
[Hide Solution]
From 1980 to 1990, real GDP grew by 39%.

(\$8,225.0 - \$5,926.5) / \$5,926.5 =
39\%($8,225.0−$5,926.5)/$5,926.5=39%left parenthesis, dollar sign, 8,
comma, 225, point, 0, minus, dollar sign, 5, comma, 926, point, 5, right
parenthesis, slash, dollar sign, 5, comma, 926, point, 5, equals, 39, percent
Over the same period, prices increased by 51%.
(\$72.7 - \$48.3) / (\$48.3/100) = 51\%($72.7−$48.3)/($48.3/100)=51%left

parenthesis, dollar sign, 72, point, 7, minus, dollar sign, 48, point, 3, right
parenthesis, slash, left parenthesis, dollar sign, 48, point, 3, slash, 100, right
parenthesis, equals, 51, percent.
So, about 57% of the growth—51 / (51 + 39)51/(51+39)51, slash, left

parenthesis, 51, plus, 39, right parenthesis—was inflation, and the remainder
—39 / (51 + 39) = 43\%39/(51+39)=43%39, slash, left parenthesis, 51, plus,
39, right parenthesis, equals, 43, percent—was growth in real GDP.
Review questions
 What is the difference between a series of economic data over time
measured in nominal terms versus the same data series over time measured in
real terms?
 How do you convert a series of nominal economic data over time to

real terms?
Critical thinking question

Should people typically pay more attention to their real income or their
nominal income? If you choose the latter, why would that make sense in
today’s world? Would your answer be the same for the 1970s?
Problems
The prime interest rate is the rate that banks charge their best
customers. Based on the nominal interest rates and inflation rates given
in the table below, in which of the years given would it have been best to
be a lender? In which of the years given would it have been best to be a
borrower?
Year Prime interest rate Inflation rate

1970 7.9% 5.7%
1974 10.8% 11.0%
1978 9.1% 7.6%
1981 18.9% 10.3%

A mortgage loan is a loan that a person makes to purchase a house. The table
below provides a list of the mortgage interest rate being charged for several
different years and the rate of inflation for each of those years. In which
years would it have been better to be a person borrowing money from a
bank to buy a home? In which years would it have been better to be a
bank lending money?
Yea
r Mortgage interest rate Inflation rate
1984 12.4% 4.3%
Yea
r Mortgage interest rate Inflation rate
1990 10% 5.4%
2001 7.0% 2.8%

[Attribution]
Lesson summary: Real vs. nominal GDP
Lesson Overview
Even GDP needs to keep it real. When we calculate GDP using today’s
prices, we are creating a measure called nominal GDP. However, prices can
change even if output doesn’t change. Because of that, our measure of output
might get distorted by something like inflation.
We account for this using real GDP, which is a measure of GDP that has
been adjusted for the price level. In this way, real GDP is a truer measure of
output in an economy. There are two approaches to adjusting nominal GDP
to get real GDP: 1) using the same prices every year or 2) using the GDP
deflator.
Key Terms
Term Definition
the market value of the final production of goods and services
nominal within a country in a given period using that year’s prices
GDP (also called “current prices”)
real GDP nominal GDP adjusted for changes in the price level, using
Term Definition
prices from a base year (constant prices) instead of “current
prices” used in nominal GDP; real GDP adjusts the level of
output for any price changes that may have occurred over time
a price index used to adjust nominal GDP to find real GDP;

the GDP deflator measures the average prices of all finished
GDP goods and services produced within a nation’s borders over
deflator time.
the year used for comparison in the determination of price

changes using the GDP deflator price index; the deflator in a
base year base year is always equal to =100=100equals, 100.
current the prices at which goods are sold in a nation in a particular

prices year; current prices are used when calculating nominal GDP.
the prices from a base year that are used to calculate real GDP
in other years; this allows for a more accurate measure of how
a country’s actual output changes over time, because using
constant constant prices cancels out any changes in the price level
prices between years.
Key takeaways
Definitions of nominal v. real GDP

Nominal GDP is a measure of how much is spent on output. For example, in
Canada during 2015, \text{CAN }\
$1{,}994.9\text{ billion}CAN $1,994.9 billionstart text, C, A, N, space, end
text, dollar sign, 1, comma, 994, point, 9, start text, space, b, i, l, l, i, o, n, end
text was spent on the goods and services produced in Canada. Nominal GDP
measures aggregate output (meaning the value of all of the final goods and
services produced) using current prices. In other words, these figures reflect
the amount spent on Canada’s output in the country’s prices in 2015.
Real GDP weighs output using prices from a base year

Real GDP is a measure of how much is actually produced. Real GDP
measures aggregate output using constant prices, thus removing the effect of
changes in the overall price level. For example, in 2015 the value of Canada’s
output expressed in constant 2010 prices was \text{CAN }\
$1{,}857\text{ bilion}CAN $1,857 bilionstart text, C, A, N, space, end text,
dollar sign, 1, comma, 857, start text, space, b, i, l, i, o, n, end text.
Here’s another way to think about Real GDP: if we add up all of the output
that was produced in Canada during 2015 by using the prices that these goods
sold for in 2010, the value of GDP in Canada is \$1{,}857\text{ billion}
$1,857 billiondollar sign, 1, comma, 857, start text, space, b, i, l, l, i, o, n, end
text. But if we add up all of the output that was produced in Canada during
2015, using the prices that they sold for in 2015, the value of GDP in Canada
is \$1{,}995\text{ billion}$1,995 billiondollar sign, 1, comma, 995, start text,
space, b, i, l, l, i, o, n, end text. This means prices must have increased
between 2010 and 2015.
However, there is a slight problem with the method above. Calculating real
GDP by weighting final goods and services by their prices in a base year can
lead to an overstatement of real GDP growth because the prices of some
goods decrease over time. Therefore, this method overstates growth in real
GDP because it makes it seem like goods make up a bigger share of spending
than they really do.
[Thanks!]
In other words, if the price of a good is going down (if it has gotten cheaper
to produce), then using a price from long ago when it was really expensive
would make it seem like a bigger deal in terms of GDP than it really is.
For example, if between 2010 and 2015 the average price of a Canadian-
made hockey stick fell from \$100$100dollar sign, 100 to \$50$50dollar sign,
50, and Canada produces 1m1m1, m hockey sticks in 2010 and
only 0.8m0.8m0, point, 8, m in 2015, the real output of hockey sticks would
have appeared to have increased (since the base year price was actually
higher than the current year price). In this way, weighting output using base
year prices can cause a country’s GDP can be overstated.
The GDP deflator and real GDP

Another method of calculating real GDP involves converting nominal GDP
to real GDP by using the GDP deflator, which tracks price changes of a
nation’s output over time. Canada’s GDP deflator for its base year of 2010
was 100100100since this is the year against which prices are compared. By
2015 the deflator had increased to 107.4107.4107, point, 4, indicating that the
average prices of Canada’s output had increased by 7.4\%7.4%7, point, 4,
percent.
By expressing 2015’s output in 2015 prices, therefore, Canada’s output

would appear to have increased by 7.4%7.47, point, 4 more than it actually
did. Canada’s nominal GDP, which has been “inflated” by higher prices, can
be “deflated” by dividing the country’s nominal GDP of \text{CAN }\
$1{,}994 \text{ billion}CAN $1,994 billionstart text, C, A, N, space, end
text, dollar sign, 1, comma, 994, start text, space, b, i, l, l, i, o, n, end text by
the deflator expressed in hundredths.
[Got it, thanks!]
Canada’s real GDP can be approximated using this method.
\begin{aligned} \text{Real GDP}&=\dfrac{\$1,994\text{ billion}}

{1.074} \\\\ &= \$1,857\end{aligned}Real GDP=1.074$1,994 billion=$1,857
Canada's real GDP can be calculated by weighting final goods and services
by their prices in a base year or by dividing nominal GDP by the GDP
deflator price index in hundredths. Either method is considered valid, but the
deflator method is more likely to account for price changes of particular
goods produced by a nation between a base year and the current year.
[Hide Source]
SOURCE: Organization for Economic Co-operation and

Development https://stats.oecd.org (accessed February 1, 2018).
Key Equations
\begin{aligned} \text{Real GDP} &=\dfrac{\text{Nominal
GDP}}{\text{GDP deflator (in hundredths)}}\\\\\text{Nominal
GDP}&=\text{Real GDP}\times\text{GDP deflator (in
hundredths)}\end{aligned}Real GDPNominal GDP=GDP deflat
or (in hundredths)Nominal GDP=Real GDP×GDP deflator (in h
undredths)
Common misperceptions:
 An increase in GDP does not necessarily mean a nation has produced
more output; it must be specified whether the GDP in question is nominal or
real. An increase in nominal GDP may just mean prices have increased, while
an increase in real GDP definitely means output increased.
 The GDP deflator is a price index, which means it tracks the average
prices of goods and services produced across all sectors of a nation's
economy over time. With this index, changes in the average price level
(inflation or deflation) can be calculated between years. However, this is not
the most commonly used price index for tracking inflation and deflation. The
consumer price index (CPI) is the most commonly used price index, which
you'll learn more about later in this course.
DIscussion questions
 Why could calculating GDP each year using current prices overstate or
understate changes in actual output year to year?
[Thanks!]
If current prices are higher than they were in previous years, then it will be
inflated by higher prices and a country’s nominal GDP will overstate the
actual change in output. On the other hand, if current prices are lower than in
previous years, the value will be deflated by lower prices and nominal GDP
will understate the actual change in output.
 Why do increases in real GDP indicate an improvement in living

standards, whereas increases in nominal GDP might not?
[Can you explain this?]
 The table below shows the output and the prices of Switzerland in 2017
and in 2018.
Goods
produce 2017 2018
d 2017 price quantity 2018 price quantity
Chocolat \$2$2dollar 40040040 \$3$3dollar 40040040
e sign, 2 0 sign, 3 0
\$6$6dollar 20020020 \$8$8dollar 20020020
Cheese sign, 6 0 sign, 8 0
\ \
$20$20dollar $22$22dollar 10010010
Watches sign, 20 808080 sign, 22 0
a) Calculate Switzerland’s nominal GDP in (i) 2017 and (ii)2018.
b) Calculate Switzerland’s real GDP in 2018 using constant 2017 prices.
c) Calculate the GDP deflator price index for 2018. How much did the
average price of goods produced in Switzerland change between 2017 and
2018?
[Thanks!]
\begin{aligned}(\text{a)(i) 2017 nominal GDP}&=(\$2 \times 400) +(\$6

\times 200) + (\$20 \times 80)\\\\ &=(\$800)+(\$1200)+(\$1600)\\ \\ &=\
$3600\\ \\ \text{(ii) 2018 nominal GDP} &=(\$3 \times 400) +(\$8 \times
210) + (\$22 \times 100)\\ \\ &=(\$1200)+(\$1680)+(\$2200)\\ \\ &=\
$5000\\ \\ \text{(b) real GDP 2018}&=(\$2 \times 400) + (\$6 \times 200) + (\
$20 \times 100)\\ \\ &=(\$800) + (\$1200)+(\$2000)\\ &=\$4000\\ \\ \text{(c)
GDP deflator for 2018 }&=\dfrac{\text{nominal GDP}_{2018}}{\text{real
GDP}_{2018}}\times 100\\\\ &=\dfrac{\$5000}{\$4000}\times 100\\ \\
&=1.25 \times 100 \\ \\ &=125\\ \\ \text{(d) Increase in GDP
deflator}&=\dfrac{125-100}{100} \times 100%\\ \\ &=125\% \end{aligned}
(a)(i) 2017 nominal GDP(ii) 2018 nominal GDP(b) real GDP 2018(c) GDP d
eflator for 2018 (d) Increase in GDP deflator=($2×400)+($6×200)+
($20×80)=($800)+($1200)+($1600)=$3600=($3×400)+($8×210)+
($22×100)=($1200)+($1680)+($2200)=$5000=($2×400)+($6×200)+
($20×100)=($800)+($1200)+($2000)=$4000=real GDP2018nominal GDP2018
×100=$4000$5000×100=1.25×100=125=100125−100×100=125% The
average price of goods increase by 25\%25%25, percent.
Tracking real GDP over time
Key points
 A business cycle is the relatively short-term movement of the economy
in and out of recession.
 A significant decline in national output is called a recession; an

especially lengthy and deep decline in output is called a depression.
 The highest point of output before a recession begins is called

the peak; the lowest point of output during the recession is called the trough.
Introduction
You might have heard a TV news reporter saying something along the lines
of "the economy grew 1.2% in the first quarter". Reports like this are
referring to percentage change in real GDP. By convention, GDP growth is
reported at an annualized rate—whatever the calculated growth in real GDP
was for a particular quarter is multiplied by four when it is reported, as if the
economy were growing at that rate for a full year.
Tracking real GDP over time
The graph below shows the pattern of US real GDP since 1900. Notice that
the generally upward longterm path of GDP has been regularly interrupted by
short-term declines.
A significant decline in real GDP is called a recession. An especially lengthy

and deep recession is called a depression. The severe drop in GDP that
occurred during the Great Depression of the 1930s—which you probably
learned about in history class—is clearly visible in the figure, as is the Great
Recession of 2008 to 2009.
US GDP, 1900–2014
The graph illustrates that both real GDP and real GDP per capita have
substantially increased since 1900.
Image credit: Figure 1 in "Tracking Real GDP over Time" by OpenStaxCollege, CC BY 4.0
Real GDP is important because it is highly correlated with other measures of

economic activity, like employment and unemployment. When real GDP
rises, so does employment.
The most significant human problem associated with recessions—and their

larger, uglier cousins, depressions—is that a slowdown in production means
that firms need to lay off or fire some of the workers they have. Losing a job
imposes painful financial and personal costs on workers and often on their
extended families as well. In addition, even those who keep their jobs are
likely to find that wage raises are scanty at best—or they may even be asked
to take pay cuts.
The highest point of the economy, before a recession begins, is called

the peak; conversely, the lowest point of a recession, before a recovery
begins, is called the trough. Thus, a recession lasts from peak to trough, and
an economic upswing runs from trough to peak.
The movement of the economy from peak to trough and trough to peak is
called the business cycle. It is intriguing to notice that the three longest
trough-to-peak expansions of the 20th century have happened since 1960.
The most recent recession started in December 2007 and ended formally in
June 2009. This was the most severe recession since the Great Depression of
the 1930s.
A private think tank, the National Bureau of Economic Research, or NBER,

is the official tracker of business cycles for the US economy. However, the
effects of a severe recession often linger on after the official ending date
assigned by the NBER.
The table below lists the pattern of recessions and expansions in the US
economy since 1899
Months of Months of
Peak Trough contraction expansion
December
June 1899 1900 18 24
September
1902 August 1904 23 21
May 1907 June 1908 13 33

Months of Months of
January 1910 Janurary 1912 24 19
December
January 1913 1914 23 12
August 1918 March 1919 7 44
January 1920 July 1921 18 10
May 1923 July 1924 14 22
November
October 1926 1927 13 27
August 1929 March 1933 43 21
May 1937 June 1938 13 50
February
1945 October 1945 8 80
November
1948 October 1949 11 37
July 1953 May 1954 10 45
August 1957 April 1958 8 39
February
April 1960 1961 10 24
December November
1969 1970 11 106
November March 1975 16 36

Months of Months of
1973
January 1980 July 1980 6 58
November
July 1981 1982 16 12
July 1990 March 1991 8 92
November
March 2001 2001 8 120
December
2007 June 2009 18 73
US business cycles since 1899
Source: http://www.nber.org/cycles/main.html
Summary
 A business cycle is the relatively short-term movement of the economy
in and out of recession.
 A significant decline in national output is called a recession; an

especially lengthy and deep decline in output is called a depression.
 The highest point of output before a recession begins is called

the peak; the lowest point of output during the recession is called the trough.
Return to the first graph in this article, but don't use the table. If a recession is
defined as a significant decline in national output, can you identify any post-
1960 recessions in addition to the recession of 2008–2009? Note: This
requires a judgment call.
[Hide solution.]
Two other major recessions are visible in the figure as slight dips: 1973 to
1975 and 1981 to 1982. Two other recessions appear in the figure as a
flattening of the path of real GDP. These were in 1990 to 1991 and 2001.
According to the table above, how often have recessions occurred since the
end of World War II—1945?
[Hide solution.]
Eleven recessions in approximately 70 years averages about one recession

every six years.
According to the table, how long has the average recession lasted since the
end of World War II?
[Hide solution.]
The table lists the months of contraction for each recession. Averaging these
figures for the post-WWII recessions gives an average duration of 11 months,
slightly less than a year.
According to the table, how long has the average expansion lasted since the
end of World War II?
[Hide solution.]
The table lists the months of expansion. Averaging these figures for the post-
WWII expansions gives an average expansion of 60.5 months, more than five
years.
Review question
What are the typical patterns of GDP for a high-income economy like the
United States in the long run and the short run?
Critical thinking questions

 Why do you suppose that US GDP is so much higher today than 50 or
100 years ago?
 Why do you think that GDP does not grow at a steady rate, but rather
speeds up and slows down?
Lesson summary: Business cycles
Lesson Overview
Heraclitus once said, “Change is the only thing that is constant.”. This
certainly applies to national economies.
Every nation’s economy fluctuates between periods of expansion and

contraction. These changes are caused by levels of employment, productivity,
and the total demand for and supply of the nation’s goods and services. In the
short-run, these changes lead to periods of expansion and recession. But in
the long-run, economic growth can occur, allowing a nation to increase its
potential level of output over time.
Key terms
Key term Definition
Key term Definition
the total demand for a nation’s output, including household
aggregate consumption, government spending, business investment,
demand and net exports
aggregate the total supply of goods and services produced by a

supply nation’s businesses
the phase of the business cycle during which output is

expansion increasing
the phase of the business cycle during which output is

recession falling
depression a deep and prolonged recession
the turning point in the business cycle between an

expansion and a contraction; during a peak in the business
cycle, output has stopped increasing and begins to
peak decrease.
the turning point in the business cycle between a recession

and an expansion; during a trough in the business cycle,
output that had been falling during the recession stage of
the business cycle bottoms out and begins to increase
trough again.
when GDP begins to increase following a contraction and a

trough in the business cycle; an economy is considered in
recovery until real GDP returns to its long-run potential
recovery level.
potential the level of output an economy can achieve when it is

Key term Definition
producing at full employment; when an economy is
producing at its potential output, it experiences only its
output natural rate of unemployment, no more and no less.
the straight line in the business cycle model, which is

growth usually upward sloping and shows the long-run pattern of
trend change in real GDP over time
the difference between actual output and potential output

when an economy is producing more than full employment
output; when there is a positive output gap, the rate of
unemployment is less than the natural rate of
positive unemployment and an economy is operating outside of its
output gap PPC.
the difference between actual output and potential output

when an economy is producing less than full employment
output; when there is a negative output gap, the rate of
negative unemployment is greater than the natural rate of
output gap unemployment and an economy is operating inside its PPC.
Key Takeaways
The business cycle

The business cycle model shows how a nation’s real GDP fluctuates over
time, going through phases as aggregate output increases and decreases. Over
the long-run, the business cycle shows a steady increase in potential output in
a growing economy.
Phases and turning points of the business cycle

The typical business cycle has four phases, which progress as follows:
Phase of
cycle Description
When real GDP is increasing and unemployment is
Expansion decreasing
The turning point in the business cycle at which output

Peak stops increasing and starts decreasing
Recession When output is decreasing and unemployment is increasing
The turning point at which a recession ends and output

Trough starts increasing again
Output gaps in the business cycle

The output gap is the difference between actual output and potential output in
the business cycle. Potential output is what a nation could be producing if all
of its resources were being used efficiently. In the business cycle model, a
nation’s potential output at any given time is represented as the long-run
growth trend.
Output gaps exist whenever the current amount that a nation is producing is
more or less than potential output. In the business cycle model, whenever the
business cycle curve is above the growth trend that means an economy is
experiencing a positive output gap. Whenever the business cycle curve is
below the growth trend that means the economy is experiencing a negative
output gap.
When actual output is above the potential output, aggregate demand has
grown faster than aggregate supply, causing the economy to overheat.
Overheating in this instance means output is occurring at an unsustainably
high level, at which the unemployment rate is lower than the natural rate of
unemployment. Eventually, the business cycle will reach a peak and enter a
recession.
When actual output is below the potential output, aggregate demand or

aggregate supply have fallen, causing a fall in employment and output. When
a negative output gap exists, the unemployment rate will be higher than the
natural rate of unemployment. Eventually, the business cycle will reach a
trough and enter a recovery and expansion.
Potential output in the business cycle

Potential output is also called full-employment output. Potential output is the
level of real GDP that would be produced if all resources are used efficiently.
For example, if labor is used efficiently, the actual rate of unemployment will
be equal to the natural rate of unemployment. When there is a positive output
gap, an economy is producing beyond its long-run potential and the
unemployment rate will be lower than the NRU. During a recession, real
GDP falls below its potential and the unemployment rate is higher than the
NRU.
The actual unemployment rate is different than the natural rate of

unemployment, at different points along the business cycle, because cyclical
unemployment changes along the business cycle. Cyclical unemployment
increases due to reduced output during recessions, and cyclical
unemployment decreases due to increased output during expansions.
Key models
The business cycle

Figure 1: A typical business cycle showing fluctuations in aggregate output over time and an overall trend
toward increasing output over time (economic growth)
The business cycle model shows the fluctuations in a nation’s aggregate
output and employment over time. The model shows the four phases an
economy experiences over the long-run: expansion, peak, recession, and
trough. The business cycle curve is represented by the solid line in the model
shown in Figure 1, and the growth trend is represented by the dashed line in
Figure 1.
Output gaps are represented by the difference between actual output. During
an expansion, the business cycle line is above the growth trend. During a
recession, the business cycle is below the growth trend.
[Thanks!]
The business cycle for the nation of Jacksonia is shown in Figure 222:
In Figure 222 we see a country experiencing long-run economic growth

(represented by the dashed line, which is increasing over this entire period),
but also experiences a recession and recovery between 2018 and 2020.
Between 2018 and 2019 GDP falls from \$2$2dollar sign, 2 trillion to \
$1.8$1.8dollar sign, 1, point, 8 trillion, leaving the economy with a \
$0.2$0.2dollar sign, 0, point, 2 trillion negative output gap. Between 2019
and 2020 the economy enters a recovery/expansion and output increases back
to \$2$2dollar sign, 2trillion. Notice, however, that even after the recovery of
2020 the country is still left with a negative output gap. That occurs because
GDP has not recovered to its potential level represented by the growth trend
in 2020. Why? Because even though output is down, the economy is likely
still creating new capital that expands its potential output in the future, even
if its current output has decreased.
The production possibilities curve (PPC)

Fluctuations experienced in the business cycle can also be illustrated using
the production possibilities curve (PPC), as in Figure 2.
\
small{1}1\small{2}2\small{3}3\small{4}4\small{5}5\small{6}6\small{7}7\small{8}8\small{9}9\small{1}1\s
mall{2}2\small{3}3\small{4}4\small{5}5\small{6}6\small{7}7\small{8}8\small{9}9\text{Consumer
goods}Consumer goods\text{Capital goods}Capital goods\text{Y}Y\text{X}X\text{}\text{Z}Z
Figure 2: Phases of the business cycle in a PPC
In the PPC above we can observe the following:
A country producing its full employment level of output is at a point on its

PPC, such as point Y. When a country approaches a peak in its business
cycle, output temporarily expands beyond the full employment level to a
point such as point Z, and there is a positive output gap. This is unsustainable
as unemployment is below its natural rate and resource scarcity will
ultimately cause output to fall. A fall in output below potential output causes
a recession and a movement to a point inside the PPC, such as point X,
resulting in a negative output gap. A recovery occurs when an economy that
is producing inside its PPC due to a recession sees its output start to increase
again, such as from point X to point Y.
 An expansion is not necessarily economic growth. When an economy is
recovering from a recession, it is in the expansion phase of the business
cycle, but it is not experiencing economic growth. Economic growth occurs
when the potential and actual output of a nation increases over time. That
growth is either shown by the dashed, upward-sloping trend line (the growth
trend) in the business cycle model, or by an outward shift of the PPC.
[Hide explanation]
Suppose an economy had been producing at its potential, full employment
output of \$2$2dollar sign, 2 trillion at point A on figure 333, but then
entered a recession and output fell to \$1.9$1.9dollar sign, 1, point, 9 trillion,
at point B.
Once the economy begins to recover and output increases to point C, the
country’s GDP increases to \$2$2dollar sign, 2 trillion. However, the
movement from B to C is a short run fluctuation that represents a change in
actual output. Growth is a change in potential output. The increase from point
A to point D does represent economic growth, because the economy’s
potential output has increased over time.
 An economy can produce beyond its full employment level of output.
Resources can be overutilized, such as workers working very, very long
hours. However, as any student who has ever pulled an all-night study
session for an exam knows, you can’t sustain that kind of effort for long.
[Hide explanation]
Suppose again an economy is producing their potential output of \

$2.5$2.5dollar sign, 2, point, 5trillion as represented by point D in
Figure 444.
Suppose that a nation’s output grows faster than it can produce sustainably
over the long run, so the nation’s firms begin hiring t structurally and
frictionally unemployed workers to meet increasing demand. By doing so, the
nation can temporarily expand its output beyond its potential to point E. But
as the unemployment rate approaches zero, further increases in actual output
become impossible. The nation’s resources will become increasingly
overworked and scarce. Eventually, output will have to return to its potential
level (point F on the graph) and unemployment will return to its natural rate.
1) Why does unemployment rise during the recession phase of the business
cycle?
[Thanks!]
A recession is characterized by falling output. As fewer goods and services

are produced, there is less need for the workers who produce them. Cyclical
unemployment increases as business lay off workers due to low demand for
their products.
2) What is the difference between a recession and a depression?
3) If a country is producing beyond its production possibilities curve, what

phase of the business cycle is it most likely experiencing?

Economic Indicators and The Business Cycle

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Macroeconomics 2:

Unit: Economic indicators and the

 Gross Domestic Product

About this unit

Measuring the size of the economy: gross domestic

 GDP can be measured either by the sum of what is purchased in the

 To avoid double counting—adding the value of output to the GDP

 The gap between exports and imports is called the trade balance. If a

The size of a nation’s overall economy is typically measured by its gross

The numbers are large, but the task is straightforward:

Step 2: Multiply it by the price at which each product sold.

Step 3: Add up the total.

Understanding how to measure GDP is important for analyzing connections

GDP measured by components of demand

 Consumer spending, or consumption

What is meant by the word investment?

Components of GDP on the demand Percentage of

Investment $2.9 16.7%

Government $3.2 18.4%

Exports $2.3 13.2%

Total GDP $17.4 100%

A few patterns are worth noticing here. Consumption expenditure by

Investment demand accounts for a far smaller percentage of US GDP than

Investment demand is very important for the economy because it is where

If you've noticed any infrastructure projects—like road construction—in your

It's important to remember that a significant portion of government budgets

Based on the four components of demand discussed above—

GDP measured by what is produced

Components of GDP on the supply Percentage of

Durable goods $2.9 16.7%

Services $10.8 62.1%

Structures $1.3 7.4%

Total GDP $17.4 100%

The category of structures includes everything from homes to office

The Problem of Double Counting

What is counted in GDP What is not included in GDP

Transfer payments and non-market

Government spending on goods and

Net exports Illegal goods

 GDP is measured by taking the quantities of all goods and services

 GDP can be measured either by the sum of what is purchased in the

 Demand can be divided into consumption, investment, government,

 To avoid double counting—adding the value of output to the GDP

 The gap between exports and imports is called the trade balance. If a

\text{GDP} = \text{C + I + G + (X - M)}GDP=C + I + G + (X - M)start text,

 The cost of hospital stays

 What are the main components of measuring GDP with what is

 Would you usually expect GDP as measured by what is demanded to

 Why must double counting be avoided when measuring GDP?

Lesson summary: The circular flow and GDP

GDP can be measured in three different ways: the value added approach,

A model called the circular flow diagram illustrates how the expenditures

one of the three approaches to calculating GDP that

an approach to calculating GDP that involves adding up

goods that are used in the production of a final product;

when using the expenditures approach, “C” is the

when using the expenditures approach, “I” is the category

government when using the expenditures approach, “G” is the

any payment by a government to a household that is not in

goods that are produced in one country and then sold

goods that are produced in a different country than where

net exports spending on exports minus spending on imports’