Money, the economy, and

inflation
Lecture # 06

Inflation
Inflation is an increase in the overall
price level.
Deflation is a decrease in the
overall price level.
Sustained inflation is an increase
in the overall price level that
continues over a significant period.

Price Indexes
Price indexes are used to measure
overall price levels. The price index
that pertains to all goods and services
in the economy is the GDP price
index.
The consumer price index (CPI) is
a price index computed each month
by the Bureau of Labor Statistics
using a bundle that is meant to
represent the market basket
purchased monthly by the typical
urban consumer.

Inflation
Good
Pizzas
Rent
Car
Phone

Year
1
Quantity Price
20
$ 10
1
$ 600
1
$ 100
1
$ 50

2
Price
$ 11
$ 640
$ 120
$ 40

3
Price
$ 13
$ 650
$ 120
$ 40

Price of basket in any given year

CPI=

-------------------------------------------Price of basket in the BASE year

The inflation rate is the percent change in the CPI

Types of Inflation
Cost Push Inflation
Demand Pull inflation
Hyper Inflation

The Costs of Inflation

Peoples income increases during
inflations, when most prices,
including input prices, tend to rise
together.
Inflation changes the distribution of
income. People living on fixed
incomes are particularly hurt by
inflation.

The Costs of Inflation

The benefits received by many
retired workers, including social
security, are fully indexed to
inflation. When prices rise, benefits
rise.
The poor have not fared so well.
Welfare benefits are not indexed and
have not kept pace with inflation.

The Costs of Inflation

Unanticipated inflationan
inflation that takes people by
surprisecan hurt creditors.
Inflation that is higher than
expected benefits debtors;
inflation that is lower than
expected benefits creditors.
The real interest rate is the
difference between the
interest rate on a loan and the
inflation rate.

The Costs of Inflation

Inflation creates administrative costs and
inefficiencies. Without inflation, time could
be used more efficiently.
The opportunity cost of holding cash is high
during inflations. People therefore hold less
cash and need to stop at the bank more
often.

Gross Domestic Product

Gross domestic
product (GDP) is the
total market value of all
final goods and services
produced within a given
period by factors of
production located
within a country.

Final Goods and Services

The term final goods and
services in GDP refers to
goods and services
produced for final use.
Intermediate goods are
goods produced by one
firm for use in further
processing by another
firm.

Value Added
Value added is the difference
between the value of goods as
they leave a stage of
production and the cost of the
goods as they entered that
stage.
In calculating GDP, we can either
sum up the value added at each
stage of production, or we can
take the value of final sales.

Value Added
Value Added in the Production of a Gallon of Gasoline
(Hypothetical Numbers)
STAGE OF PRODUCTION

VALUE OF SALES

VALUE ADDED

$ .50

$ .50

(2) Refining

.65

.15

(3) Shipping

.80

.15

1.00

.20

(1) Oil drilling

(4) Retail sale

Total value added

$1.00

Exclusions of Used Goods

and Paper Transactions
GDP ignores all
transactions in which
money or goods change
hands but in which no new
goods and services are
produced.

Exclusion of Output Produced Abroad

by Domestically Owned Factors of
Production
GDP is the value of output
produced by factors of
production located within a
country. Output produced by a
countrys citizens, regardless of
where the output is produced, is
measured by gross national
product (GNP).

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Calculating GDP
GDP can be computed in two ways:
The expenditure approach: A
method of computing GDP that
measures the total amount spent on
all final goods during a given period.
The income approach: A method of
computing GDP that measures the
incomewages, rents, interest, and
profitsreceived by all factors of
production in producing final goods.

The Expenditure Approach

Expenditure categories:
Personal consumption
expenditures (C)household
spending on consumer goods.
Gross private domestic
investment (I)spending by firms
and households on new capital:
plant, equipment, inventory, and new
residential structures.
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The Expenditure Approach

Expenditure categories:

Government consumption
and gross investment (G)
Net exports (EX IM)net
spending by the rest of the world, or
exports (EX) minus imports (IM)

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The Expenditure Approach

The expenditure approach
calculates GDP by adding
together the four
components of spending. In
equation
form:
G D P C I G ( E X IM )

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Components of GDP, 1999:

The Expenditure Approach
Components of GDP, 2002: The Expenditure Approach
Personal consumption expenditures (C)
Durable goods
Nondurable goods
Services
Gross private domestic investment (l)
Nonresidential
Residential
Change in business inventories
Government consumption and gross investment (G)
Federal
State and local
Net exports (EX IM)
Exports (EX)
Imports (IM)
Total gross domestic product (GDP)
Note: Numbers may not add exactly because of rounding.
Source:
U.S. Department of Commerce, Bureau of Economic Analysis.
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BILLIONS OF
DOLLARS

PERCENTAGE
OF GDP

7303.7
871.9
2115.0
4316.8
1543.2
1117.4
471.9
3.9
1972.9
693.7
1279.2
423.6
1014.9
1438.5
10446.2

69.9
8.3
20.2
41.3
14.8
10.7
4.5
0
18.9
6.6
12.2
4.1
9.8
13.8
100.0

Personal Consumption
Expenditures
Personal consumption expenditures
(C) are expenditures by consumers on
the following:
Durable goods: Goods that last a
relatively long time, such as cars and
appliances.

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Nondurable goods: Goods that are used

up fairly quickly, such as food and
clothing.
Services: Things that do not involve the
production of physical things, such as
legal services, medical services, and
education.

Gross Private Domestic

Investment

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Investment refers to the

purchase of new capital.
Total investment by the
private sector is called gross
private domestic
investment. It includes the
purchase of new housing,
plants, equipment, and
inventory by the private
sector.

Gross Private Domestic

Investment
Nonresidential investment includes
expenditures by firms for machines,
tools, plants, and so on.
Residential investment includes
expenditures by households and firms
on new houses and apartment
buildings.
Change in inventories computes the
amount by which firms inventories
change during a given period.
Inventories are the goods that firms
produce now but intend to sell later.
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Gross Private Domestic

Investment
Remember that GDP is not
the market value of total
sales during a periodit is
the market value of total
production.
The relationship between
GDP = final
sales + change in business
total
production
and inventories
total
sales is:
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Gross Investment
versus Net Investment
Gross investment is the total value
of all newly produced capital goods
(plant, equipment, housing, and
inventory) produced in a given period.
Depreciation is the amount by
which an assets value falls in a given
period.
Net investment equals gross
investment minus depreciation.

capitalend of period = capitalbeginning of period + net investment

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Government Consumption
and Gross Investment
Government
consumption and
gross investment (G)
counts expenditures by
federal, state, and local
governments for final
goods and services.

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Net Exports
Net exports (EX IM) is the
difference between exports
and imports. The figure can
be positive or negative.
Exports (EX) are sales to
foreigners of U.S.-produced
goods and services.
Imports (IM) are U.S.
purchases of goods and
services from abroad).
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The Income Approach

National income is the total
income earned by the factors of
production owned by a
countrys citizens.
The income approach to GDP
breaks down GDP into four
components:
GDP = national income + depreciation + (indirect taxes subsidies) +
net factor payments to the rest of the world + other

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The Income Approach

Components of GDP, 2002: The Income Approach
BILLIONS OF
DOLLARS

PERCENTAGE
OF GDP

8,199.9

80.3

6,010.0

58.9

Proprietors income

943.5

7.3

Corporate profits

748.9

7.3

Net interest

554.8

5.4

Rental income

142.7

1.4

National income
Compensation of employees

Depreciation
Indirect taxes minus subsidies
Net factor payments to the rest of the world
Other
Gross domestic product
Source: See Table 18.2.

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1,351.3
739.4
11.1
96.1
10,205.6

13.2
7.2
0.1
0.9
100.0

From GDP to Disposable Personal

Income
GDP, GNP, NNP, National Income, Personal Income, and Disposable Personal Income, 2002

GDP
Plus: receipts of factor income from the rest of the world
Less: payments of factor income to the rest of the world

Equals: GNP
Less: depreciation

Equals: net national product (NNP)

Less: indirect taxes minus subsidies plus other

Equals: national income

Less:
Less:
Plus:
Plus:

corporate profits minus dividends

social insurance payments
personal interest income received from the government and consumers
transfer payments to persons

Equals: personal income

Less: personal taxes

Equals: disposable personal income

Source: See Table 18.2.

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DOLLARS
(BILLIONS)
10,205.6
+ 342.1
353.2
10,194.5
1,351.3
8,843.2
643.3
8,199.9
332.6
731.2
+ 439.1
+1,148.7
8,723.9
1,306.2
7,417.7

From GDP to Disposable Personal

Income
Net national product equals gross
national product minus
depreciation; a nations total
product minus what is required to
maintain the value of its capital
stock.
Personal income is the income
received by households after paying
social insurance taxes but before
paying personal income taxes.
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Disposable Personal
Income and Personal Saving
Disposable Personal Income and Personal Saving, 2002
DOLLARS
(BILLIONS)
Disposable personal income
Less:
Personal consumption expenditures
Interest paid by consumers to business
Personal transfer payments to foreigners
Equals: personal saving
Personal savings as a percentage of disposable personal income:
Source: See Table 18.2.

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7,417.7
7063.5
204.3
31.3
118.6
1.6%

Disposable Personal Income

and Personal Saving
The personal saving rate is
the percentage of disposable
personal income that is saved.
If the personal saving rate is
low, households are spending a
large amount relative to their
incomes; if it is high,
households are spending
cautiously.
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Nominal Versus Real GDP

Nominal GDP is GDP measured in
current dollars, or the current
prices we pay for things. Nominal
GDP includes all the components of
GDP valued at their current prices.
When a variable is measured in
current dollars, it is described in
nominal terms.
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Calculating Real GDP

A weight is the importance attached
to an item within a group of items.
A base year is the year chosen for
the weights in a fixed-weight
procedure.
A fixed-weight procedure uses
weights from a given base year.

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Calculating Real GDP

A Three-Good Economy
(1)

(2)

PRODUCTION
YEAR 1
YEAR 2
Q1
Q2

(3)

(4)

PRICE PER UNIT

YEAR 1
YEAR 2
P1
P2

(5)

(6)

(7)

(8)

GDP IN
YEAR 1
IN
YEAR 1
PRICES
P 1 x Q1

GDP IN
YEAR 2
IN
YEAR 1
PRICES
P 1 x Q2

GDP IN
YEAR 1
IN
YEAR 2
PRICES
P2 x Q1

GDP IN
YEAR 2
IN
YEAR 2
PRICES
P2 X Q2

Good A

11

$.50

$ .40

$3.00

$5.50

$2.40

$4.40

Good B

.30

1.00

2.10

1.20

7.00

4.00

Good C

10

12

.70

.90

7.00

8.40

9.00

10.80

$12.10

$15.10

$18.40

$19.20

Total

Nominal
GDP
in year 1

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Nominal
GDP
in year 2

Calculating the GDP

Deflator
The GDP deflator is one measure of
the overall price level. The GDP
deflator is computed by the Bureau of
Economic Analysis (BEA).
Overall price increases can be
sensitive to the choice of the base
year. For this reason, using fixedprice weights to compute real GDP
has some problems.
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The Problems of Fixed

Weights
The use of fixed price weights to
estimate real GDP leads to problems
because it ignores:

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1. Structural changes in the

economy.
2. Supply shifts, which cause
large decreases in price and
large increases in quantity
supplied.
3. The substitution effect of price
increases.

GDP and Social Welfare

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Society is better off when

crime decreases, however, a
decrease in crime is not
reflected in GDP.
An increase in leisure is an
increase in social welfare, but
not counted in GDP.
Nonmarket and household
activities are not counted in
GDP even though they amount
to real production.

GDP and Social Welfare

GDP accounting rules do not
adjust for production that
pollutes the environment.
GDP has nothing to say about
the distribution of output.
Redistributive income policies
have no direct impact on GDP.
GDP is neutral to the kinds of
goods an economy produces.
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The Underground Economy

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The underground
economy is the part of
an economy in which
transactions take place
and in which income is
generated that is
unreported and
therefore not counted in
GDP.

Gross National Income per

Capita
To make comparisons of GNP between
countries, currency exchange rates
must be taken into account.
Gross National Income (GNI) is a
measure used to make international
comparisons of output. GNI is GNP
converted into dollars using an
average of currency exchange rates
over several years adjusted for rates
of inflation.
GNI divided by population equals
gross national income per capita.
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Gross National Income per

Capita
Per Capita Gross National Income for Selected Countries, 2002
COUNTRY
Switzerland
Japan
Norway
United States
Denmark
Ireland
Sweden
United Kingdom
Netherlands
Austria
Finland
Germany
Belgium
France
Canada
Australia
Italy
Spain
Greece

U.S. DOLLARS
36,970
35,990
35,530
34,870
31,090
28,880
25,400
24,230
24,040
23,940
23,840
23,700
23,340
22,640
21,340
18,770
18,470
14,860
11,780

The World Bank Atlas, 2002.

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38

COUNTRY
Portugal
South Korea
Argentina
Mexico
Czech Republic
Brazil
South Africa
Turkey
Colombia
Jordan
Romania
Philippines
China
Indonesia
India
Pakistan
Nepal
Rwanda
Ethiopia

U.S. DOLLARS
10,670
9,400
6,860
5,540
5,270
3,060
2,900
2,540
1,910
1,750
1,710
1,050
890
680
460
420
250
220
100