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Jeans 30.00 25
on television that the “cost of living rose by 0.2 per-
Movie ticket 7.00 40
cent last month,” chances are the reporter is referring
to the CPI.
Pricing the 1983 student budget at 2007 prices, we
The Consumer Price Index (CPI) is measured by pricing
find that what once cost $100 now costs $142, as the
the items on a list representative of a typical urban
household budget. calculation in Table 7 shows. Thus, the SPI, based on
1983 5 100, is
To know which items to include and in what
amounts, the BLS conducts an extensive survey of Cost of budget in 2007
SPI 5 3 100
spending habits roughly once every decade. As a con- Cost of budget in 1983
sequence, the same bundle of goods and services is
$142
used as a standard for 10 years or more, whether or 3 100 5 142
5
$100
not spending habits change.10 Of course, spending
habits do change, and this variation introduces a
TA BL E 7
small error into the CPI™s measurement of inflation.
A simple example will help us understand how the Cost of 1983 Student Budget in
2007 Prices
CPI is constructed. Imagine that college students pur-
chase only three items”hamburgers, jeans, and 70 Hamburgers at $1.20 $84
1 pair of jeans at $30 30
movie tickets”and that we want to devise a cost-of-
4 movie tickets at $7 28
living index (call it SPI, or “Student Price Index”) for
Total $142
them. First, we would conduct a survey of spending
habits in the base year. (Suppose it is 1983.) Table 5
represents the hypothetical results. You will note that So, the SPI in 2007 stands at 142, meaning that stu-
the frugal students of that day spent only $100 per dents™ cost of living has increased 42 percent over the
month: $56 on hamburgers, $24 on jeans, and $20 on 24 years.
movies.

TA BL E 5 USING A PRICE INDEX TO “DEFLATE”
Results of Student Expenditure Survey, 1983
MONETARY FIGURES
Average
Quantity Average One of the most common uses of price indexes is in
Average Purchased Expenditure the comparison of monetary figures relating to two
Item Price per Month per Month
different points in time. The problem is that if there
Hamburger $ 0.80 70 $56 has been inflation, the dollar is not a good measuring
Jeans 24.00 1 24
rod because it can buy less now than it did in the past.
Movie ticket 5.00 4 20
Here is a simple example. Suppose the average stu-
Total $100
dent spent $100 per month in 1983 but $140 per month
in 2007. If there was an outcry that students had be-
Table 6 presents hypothetical prices of these same come spendthrifts, how would you answer the charge?
three items in 2007. Each price has risen by a different The obvious answer is that a dollar in 2007 does not
amount, ranging from 25 percent for jeans up to buy what it did in 1983. Specifically, our SPI shows us
50 percent for hamburgers. By how much has the SPI that it takes $1.42 in 2007 to purchase what $1 would
risen? purchase in 1983. To compare the spending habits of stu-
dents in the two years, we must divide the 2007 spend-
ing figure by 1.42. Specifically, real spending per student
in 2007 (where “real” is defined by 1983 dollars) is:
Economists call this a base-period weight index because the relative
10

Nominal spending in 2007
Real spending
importance it attaches to the price of each item depends on how
3 100
5
much money consumers actually chose to spend on the item during
in 2007 Price index of 2007
the base period.




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Chapter 6 129
The Goals of Macroeconomic Policy



Thus: THE GDP DEFLATOR
$140
Real spending in 2007 5 3 100 5 $98.59 In macroeconomics, one of the most important of the
142
monetary magnitudes that we have to deflate is the
This calculation shows that, despite appearances to nominal gross domestic product (GDP).
the contrary, the change in nominal spending from
The price index used to deflate nominal GDP is called
$100 to $140 actually represented a small decrease in
the GDP deflator. It is a broad measure of economy-
real spending. wide inflation that includes the prices of all goods and
This procedure of dividing by the price index is services in the economy.
called deflating, and it serves to translate noncompa-
Our general principle for deflating a nominal mag-
rable monetary figures into more directly comparable
nitude tells us how to go from nominal GDP to real
real figures.
GDP:
Deflating is the process of finding the real value of some
monetary magnitude by dividing by some appropriate Nominal GDP
Real GDP 5 3 100
price index. GDP deflator
A good practical illustration is the real wage, a concept
As with the CPI, the 100 simply serves to establish
we have discussed in this chapter. As we saw in the
the base of the index as 100, rather than 1.00.
boxed insert on page 118, we obtain the real wage by
Some economists consider the GDP deflator to be a
dividing the nominal wage by the price level.
better measure of overall inflation than the Consumer
Price Index. The main reason is that the GDP deflator
USING A PRICE INDEX TO is based on a broader market basket. As mentioned
MEASURE INFLATION earlier, the CPI is based on the budget of a typical ur-
ban family. By contrast, the GDP deflator is con-
In addition to deflating nominal magnitudes, price in- structed from a market basket that includes every item
dexes are commonly used to measure inflation, that is, in the GDP”that is, every final good and service pro-
the rate of increase of the price level. The procedure is duced by the economy. Thus, in addition to prices of
straightforward. The data on the inside back cover (Col- consumer goods, the GDP deflator includes the prices
umn 13) show that the CPI was 49.3 in 1974 and 44.4 in of airplanes, lathes, and other goods purchased by
1973. The ratio of these two numbers, 49.3/44.4, is 1.11, businesses”especially computers, which fall in price
which means that the 1974 price level was 11 percent every year. It also includes government services. For
greater than the 1973 price level. Thus, the inflation rate this reason, the two indexes rarely give the same
between 1973 and 1974 was 11 percent. The same proce- measure of inflation. Usually the discrepancy is mi-
dure holds for any two adjacent years. Most recently, the nor. But sometimes it can be noticeable, as in 2000
CPI rose from 201.6 in 2006 to 207.3 in 2007. The ratio of when the CPI recorded a 3.4 percent inflation rate
these two numbers is 207.3/201.6 5 1.028, meaning that over 1999 while the GDP deflator recorded an infla-
the inflation rate from 2006 to 2007 was 2.8 percent. tion rate of only 2.2 percent.




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Licensed to:
Part 2
130 The Macroeconomy: Aggregate Supply and Demand



| SUMMARY |
1. Inflation is measured by the percentage increase in an 4. Price indexes such as the CPI can be used to deflate
index number of prices, which shows how the cost of nominal figures to make them more comparable. Defla-
some basket of goods has changed over a period of time. tion amounts to dividing the nominal magnitude by the
appropriate price index.
2. Because relative prices are always changing, and be-
cause different families purchase different items, no 5. The inflation rate between two adjacent years is com-
price index can represent precisely the experience of puted as the percentage change in the price index be-
every family. tween the first year and the second year.
3. The Consumer Price Index (CPI) tries to measure the 6. The GDP deflator is a broader measure of economy-
cost of living for an average urban household by pricing wide inflation than the CPI because it includes the prices
a typical market basket every month. of all goods and services in the economy.




| KEY TERMS |
Price index 127 Consumer Price Index (CPI) 128 GDP deflator 129
Index number problem 127 Deflating 129




| TEST YOURSELF |
1. Below you will find the yearly average values of the 3. Fill in the blanks in the following table of GDP statistics:
Dow Jones Industrial Average, the most popular index
of stock market prices, for four different years. The Con-
2005 2006 2007
sumer Price Index for each year (on a base of 1982“1984 5
100) can be found on the inside back cover of this book. Nominal GDP 12,434 13,843
Use these numbers to deflate all five stock market val- Real GDP 11,003 11,319
GDP deflator 116.6 119.7
ues. Do real stock prices always rise every decade?


Dow Jones
4. Use the following data to compute the College Price
Year Industrial Average
Index for 2007 using the base 1982 = 100.
1970 753
1980 891
1990 2,679
Price Quantity Price
2000 10,735
in per Month in
Item 1982 in 1982 2007
Button-down shirts $10 1 $25
2. Below you will find nominal GDP and the GDP deflator
Loafers 25 1 55
(based on 2000 5 100) for the years 1987, 1997, and 2007.
Sneakers 10 3 35
a. Compute real GDP for each year. Textbooks 12 12 40
Jeans 12 3 30
b. Compute the percentage change in nominal and real
Restaurant meals 5 11 14
GDP from 1987 to 1997, and from 1997 to 2007.
c. Compute the percentage change in the GDP deflator
over these two periods.
5. Average hourly earnings in the U.S. economy during
several past years were as follows:
GDP Statistics 1987 1997 2007
Nominal GDP
1970 1980 1990 2000
(Billions of dollars) 4,740 8,304 13,843
GDP deflator 73.2 95.4 119.7 $3.23 $6.66 $10.01 $13.75




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Chapter 6 131
The Goals of Macroeconomic Policy



b. Compute the weighted average of the percentage in-
Use the CPI numbers provided on the inside back cover
creases of the three prices shown in Table 6, using the
of this book to calculate the real wage (in 1982“1984 dol-
expenditure weights you just computed.
lars) for each of these years. Which decade had the
fastest growth of money wages? Which had the fastest You should get 42 percent as your answer. This shows
growth of real wages? that inflation, as measured by the SPI, is a weighted av-
erage of the percentage price increases of all the items
6. The example in the appendix showed that the Student
that are included in the index.
Price Index (SPI) rose by 42 percent from 1983 to 2007.
You can understand the meaning of this better if you do
the following:
a. Use Table 5 to compute the fraction of total spending
accounted for by each of the three items in 1983. Call
these values the “expenditure weights.”




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Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:




Economic Growth: Theory and Policy
Once one starts to think about . . . [differences in growth rates among countries],
it is hard to think about anything else.
RO B E RT E . LU CA S , J R . ,
1995 NOBEL PRIZE WINNER IN ECONOMICS



W hy do some economies grow rapidly while others grow slowly”or not at all?
As the opening quotation suggests, there is probably no more important ques-
tion in all of economics. From 1990 to 2005, according to the World Bank, the American
economy grew at a 3.2 percent annual rate, while China™s grew 10.3 percent per year
and Russia™s declined (on average) by 1.2 percent per year. Those are very large differ-
ences. What factors account for such disparities?
The discussion in Chapter 6 of the goal of economic growth focused our attention on
two crucial but distinct tasks for macroeconomic policy makers, both of which are quite
difficult to achieve:
• Growth policy: Ensuring that the economy sustains a high long-run growth rate
of potential GDP (although not necessarily the highest possible growth rate)
• Stabilization policy: Keeping actual GDP reasonably close to potential GDP in

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