Measuring a Nation’s Income

and Cost of Living

Unit 1
Unit 1
Measuring a Nation’s Income and Cost of Living (10 Hours)

Economy’s Income and Expenditure-Measurement of GDP- Components of GDP-

Real versus Nominal GDP- The GDP Deflator; The Consumer Price Index (CPI)-
Calculation of CPI- GDP Deflator versus CPI- Correcting economic variables for
the effects of inflation- Real and Nominal Interest Rates-Limitations
● Civilizations in the Middle East, China, and elsewhere employed
sophisticated financial concepts and produced written guides of best
economic practices and norms in the first millennium BCE.
● Tunisian philosopher Khaldun, writing in the 14th century, was among
the first theorists to examine the division of labor, profit motive, and
international trade.
● In the 18th century, Scottish economist Adam Smith used the ideas of
French Enlightenment writers to develop a thesis on how economies
should work. In the 19th century, Karl Marx and Thomas Malthus
expanded on their work.
● Late-19th century economists Léon Walras and Alfred Marshall used
statistics and mathematics to express economic concepts, such as
economies of scale.

● John Maynard Keynes developed theories in the early 20th century that
the Federal Reserve still uses to manage monetary policy today.
● Most modern economic theories are based on the work of Keynes and the
free-market theories of Milton Friedman, which suggest more capital in
the system lessens the need for government involvement.
● More recent theories, such as those of Harvard University economist
Amartya Sen, argue for factoring ethics into social welfare calculations of
economic efficiency.
What is Macroeconomics?
● Macroeconomics is a branch of economics that studies how an
overall economy—the markets, businesses, consumers, and
governments—behave.
● Macroeconomics examines economy-wide phenomena such as
inflation, price levels, rate of economic growth, national income,
gross domestic product (GDP), and changes in unemployment.
What is Macroeconomics?
● Some of the key questions addressed by macroeconomics include:

○ What causes unemployment?

○ What causes inflation?

○ What creates or stimulates economic growth?

● Macroeconomics attempts to measure how well an economy is

performing, understand what forces drive it, and project how
performance can improve.
Understanding Macroeconomics

● Macroeconomics is a field of study that analyzes an economy

through a wide lens.
● This includes looking at variables like unemployment, GDP,
and inflation. In addition, macroeconomists develop models
explaining the relationships between these factors.
Understanding Macroeconomics

● These models, and the forecasts they produce, are used by

government entities to aid in constructing and evaluating economic,
monetary, and fiscal policy.
● Businesses use the models to set strategies in domestic and global
markets.
● Investors use them to predict and plan for movements in various
asset classes.
Macroeconomic Indicators
Economic Growth

● Economic growth refers to an increase in aggregate production in an economy.

Macroeconomists try to understand the factors that either promote or retard
economic growth to support economic policies that will support development,
progress, and rising living standards.
○ Gross Domestic Product indicators: Measure how much the economy produces

○ Consumer Spending indicators: Measure how much capital consumers feed back into the
economy

○ Income and Savings indicators: Measures how much consumers make and save

○ Industry Performance indicators: Measures GDP by industry

Macroeconomic Indicators
Economic Growth
○ International Trade and Investment indicators: Indicates the balance of payments between
trade partners, how much is traded, and how much is invested internationally

○ Prices and Inflation indicators: Indicate fluctuations in prices paid for goods and services and
changes in currency purchasing power

○ Investment in Fixed Assets indicators: Indicate how much capital is tied up in fixed assets

○ Employment indicators: Shows employment by industry, state, county, and other areas

○ Government indicators: Shows how much the government spends and receives

○ Special indicators: All other economic indicators, such as distribution of personal income,
global value chains, healthcare spending, small business well-being, and more
Macroeconomic Indicators
The Business Cycle
GDP
● Gross domestic product (GDP) is the total monetary or market value of all the finished goods
and services produced within a country’s borders in a specific time period. As a broad measure
of overall domestic production, it functions as a comprehensive scorecard of a given country’s
economic health.

● The calculation of a country’s GDP encompasses all private and public consumption,
government outlays, investments, additions to private inventories, paid-in construction costs,
and the foreign balance of trade.
Nominal GDP (GDP at current prices)

● Nominal GDP is an assessment of economic production in an economy that

includes current prices in its calculation.
● In other words, it doesn’t strip out inflation or the pace of rising prices, which can
inflate the growth figure.
● All goods and services counted in nominal GDP are valued at the prices that those
goods and services are actually sold for in that year.
● Nominal GDP is evaluated in either the local currency or U.S. dollars at currency
market exchange rates to compare countries’ GDPs in purely financial terms.
● Nominal GDP is used when comparing different quarters of output within the same
year.
● When comparing the GDP of two or more years, real GDP is used. This is because,
in effect, the removal of the influence of inflation allows the comparison of the
different years to focus solely on volume.
Real GDP (GDP at constant prices)

● Real gross domestic product (GDP) is an inflation-adjusted measure that reflects

the value of all goods and services produced by an economy in a given year.
● Real GDP is expressed in base-year prices. It is often referred to as constant-price
GDP, inflation-corrected GDP, or constant dollar GDP.
● Put simply, real GDP measures the total economic output of a country and is
adjusted for changes in price.
Gross Domestic Product at Factor Cost
● The total cost incurred in deploying all factors, which led to the production or generation of
goods and commodities available in the market, is known as factor cost.

● GDP at Factor cost is the total value of goods and commodities produced in a year in a country
by its all-production units. This value calculated here is inclusive of depreciation as well.

GDP at Factor Cost = Sum of all GVA at factor cost.

Gross Domestic Product at Market Prices
● The market price is a measure of the amount at which goods or commodities are made available
to the general consumer for sale.

● This total cost is inclusive of the entire production cost right from the purchase of raw material
to worker wages, input prices, rent, interest, profit, etc.

GDP at Market Price = GDP at factor cost + Product taxes + Production tax – Product
subsidies – Production subsidies.
The components of GDP
GDP = C + I + G + (X - M)

● C is the quantity of goods produced for consumption

● I is the quantity of investments made

○ C + I together represent the private sectors contribution

● G is the quantity of goods produced by the government and

● X - M is exports minus imports i.e. the net contribution that exports have made to the
GDP
The GDP Deflator
● The GDP deflator, also called implicit price deflator, is a measure of inflation.

● It is the ratio of the value of goods and services an economy produces in a particular year at
current prices to that of prices that prevailed during the base year.

● This ratio helps show the extent to which the increase in gross domestic product has happened
on account of higher prices rather than increase in output.

● Since the deflator covers the entire range of goods and services produced in the economy — as
against the limited commodity baskets for the wholesale or consumer price indices — it is seen
as a more comprehensive measure of inflation.
The GDP Deflator
● GDP price deflator measures the difference between real GDP and nominal GDP. Nominal
GDP differs from real GDP as the former doesn’t include inflation, while the latter does.

● As a result, nominal GDP will most often be higher than real GDP in an expanding economy.

● The formula to find the GDP price deflator:

GDP price deflator = (nominal GDP ÷ real GDP) x 100

CPI
● A Consumer Price Index (CPI) is designed to measure the changes over time in general level of
retail prices of selected goods and services that households purchase for the purpose of
consumption.

● Such changes affect the real purchasing power of consumers’ income and their welfare. The CPI
measures price changes by comparing, through time, the cost of a fixed basket of commodities.

● The basket is based on the expenditures of a target population in a certain reference period.
Since the basket contains commodities of unchanging or equivalent quantity and quality, the
index reflects only pure price.
CPI
● Traditionally, CPI numbers were originally introduced to provide a measure of changes in the
living costs of workers, so that their wages could be compensated to the changing level of
prices.

● However, over the years, CPIs have been widely used as a macroeconomic indicator of inflation,
and also as a tool by Government and Central Bank for targeting inflation and monitoring price
stability.

● CPI is also used as deflators in the National Accounts.

● CPI is considered as one of the most important economic indicators.

How the CPI Is Calculated
1. Fix the “basket.”

Ministry of Statistics and Programme Implementation determine what’s in the typical consumer’s
“shopping basket.”

2. Find the prices.

Collects data on the prices of all the goods in the basket.

3. Compute the basket’s cost.

Use the prices to compute the total cost of the basket.

How the CPI Is Calculated
4. Choose a base year and compute the index.
The CPI in any year equals

100 X cost of basket in current year / cost of basket in base year

5. Compute the inflation rate.

The percentage change in the CPI from the preceding period.

Inflation rate = (CPI this year – CPI last year)/CPI last year
Problems with the CPI

Substitution Bias
▪ Over time, some prices rise faster than others.

▪ Consumers substitute toward goods that become relatively cheaper.

▪ The CPI misses this substitution because it uses a fixed basket of goods.

▪ Thus, the CPI overstates increases in the cost of living.

Problems with the CPI
Introduction of New Goods
▪ The introduction of new goods increases variety, allows consumers to find products that
more closely meet their needs.

▪ The CPI misses this effect because it uses a fixed basket of goods.

▪ Thus, the CPI overstates increases in the cost of living.

Problems with the CPI
Unmeasured Quality Change
▪ Improvements in the quality of goods in the basket increase the value of each
dollar/rupee.

▪ The agency tries to account for quality changes but probably misses some, as
quality is hard to measure.

▪ Thus, the CPI overstates increases in the cost of living.

Contrasting the CPI and GDP Deflator
In each scenario, determine the effects on the CPI and the GDP
deflator.
A. CCD raises the price of DARK FOREST COFFEE POWDER

The CPI and GDP deflator both rise.

B. Mahindra & Mahindra raises the price of the industrial tractors it

manufactures at its Mumbai factory.

The GDP deflator rises, the CPI does not.

C. Armani raises the price of the Italian jeans it sells in the U.S.

The CPI rises, the GDP deflator does not.

Correcting economic variables for the effects of
inflation
Comparing Dollar Figures from Different Times

Inflation makes it harder to compare dollar amounts from different times.

Example: the minimum wage

$1.25 in Dec 1963

$7.25 in Dec 2013

Did min wage have more purchasing power in Dec 1963 or Dec 2013?

To compare, use CPI to convert 1963 figure into “2013 dollars”…

Comparing Dollar Figures from Different
Times

● In our example, “year T ” is 12/1963, “today” is 12/2013

● Min wage was $1.25 in year T
● CPI = 30.9 in year T, CPI = 234.6 today

$1.25 X (234.6 / 30.9) = $9.49

The minimum wage in 1963 was $9.49 in 2013 dollars.

Correcting Variables for Inflation

Comparing Dollar Figures from Different Times

▪ Researchers, business analysts and policymakers often use this technique to convert a time series of
current-dollar (nominal) figures into constant-dollar (real) figures.

▪ They can then see how a variable has changed over time after correcting for inflation.

▪ Example: the minimum wage, from Jan 1950 to Dec 2007

Correcting Variables for Inflation

Indexation
● Price indexes are used to correct for the effects of inflation when comparing dollar figures from
different times.

● This type of correction shows up in many places in the economy. When some dollar amount is
automatically corrected for changes in the price level by law or contract, the amount is said to be
indexed for inflation.

● For example, many long-term contracts between firms and unions include partial or complete
indexation of the wage to the CPI. Such a provision, called a cost-of living allowance (or
COLA), automatically raises the wage when the CPI rises.
Correcting Variables for Inflation

Real and Nominal Interest Rates

● The very concept of an interest rate necessarily involves comparing amounts of money at
different points in time.

● When you deposit your savings in a bank account, you give the bank some money now, and the
bank returns your deposit with interest in the future. Similarly, when you borrow from a bank,
you get some money now, but you will have to repay the loan with interest in the future. In both
cases, to fully understand the deal between you and the bank, it is crucial to acknowledge that
future dollars could have a different value than today’s dollars.

● That is, you have to correct for the effects of inflation.

Correcting Variables for Inflation

Real and Nominal Interest Rates

● To understand how much a person earns in a savings account, we need to consider both the interest rate
and the change in prices. The interest rate that measures the change in dollar amounts is called the
nominal interest rate, and the interest rate corrected for inflation is called the real interest rate.

● The nominal interest rate, the real interest rate, and inflation are related approximately as follows:

○ Real interest rate = Nominal interest rate - Inflation rate.

● The real interest rate is the difference between the nominal interest rate and the rate of inflation. The
nominal interest rate tells you how fast the number of dollars in your bank account rises over time, while
the real interest rate tells you how fast the purchasing power of your bank account rises over time.