Inflation & Real Vs Nominal Gross Domestic Product
This lesson discusses the difference between Real and Nominal GDP.
Real GDP is adjusted for inflation calculated at a base price. For the US, 2012 is the base year. Refer to the Federal Funds Rates & Taylor’s Rule posted under Applied Learning on The middle Road. Below is an educational video explaining the difference between Real and Nominal Gross Domestic Product. The video also introduces inflation and calculation of Consumer Price Index.
Refer to the below read on CPI, specifically focusing on the United States of America. The following is part of the read Federal Funds Rate and Taylor’s Rule posted under Applied Learning.
Consumer Price Index or Cost of Living Index or CPI
Inflation is the increase in an economy’s price levels over a period. Inflation is tracked through price indexes. All countries do not go through inflation. There are periods of deflation, hyperinflation, and disinflation in an economy. For the US, the Consumer Price Index or the Cost of Living Index is the most widely watched price index. Consumer Price Index (CPI), is a measure produced by the Bureau of Labor Statistics (BLS) and calculated monthly. The Consumer Price Index (CPI) measures the average change over time in the prices paid by urban consumers for a constant quality market basket of consumer goods and services.
The central bank of Sweden Riksbank defines the cost of living index as the relationship between the monetary amounts required to maintain, the same consumption standard, or the same level of benefit. It compares prices and the consumption level of the population.
Other price indexes in the US explained below.
Gross Domestic Purchases Price Index is the broadest measure of inflation within the US economy. GDP Price Index is BEA’s featured measure of the US economy. Like an implicit price deflator, the GDP Price Index measures price changes in goods and services purchased by consumers, businesses, the government, and foreigners but not by importers. The FED closely watches the PCE Price Index and core PCE price index, PCE Price Index is similar to CPI, but the method of calculating and its use are different. Core inflation doesn’t include food, energy, and alcohol prices, therefore less volatile than inflation. PCE Price Index only includes consumer purchases, i.e., households, and not exports. Both PCE Price Index and core PCE price index are closely watched by the FED. The GDP deflator, another price index, is important and is discussed below. CPI is based on a Laspeyres-type index with weights based on a base or historical year, while the Paasche index uses formula weights from the current year. CPI suffers from an upward bias since its basket of goods is constant; an increase in the price of a product might lead the consumer to substitute for another cheaper product, which is not reflected in the calculation. PCE is based on the Fisher-Price Index, geometric of Laspeyres and Paasche index. Inflation can be either due to demand-pull or cost-push. Demand-pull is when demand for goods and services exceeds the supply for goods and services, or cost-push is when the prices of input goods and services increase due to supply shock, exchange rates, etc.
CPI Vs GDP Deflator | The middle Road
GDP Implicit Price Deflator (IPD) or GDP Deflator: This is another measure that captures inflation in the US, a measure of the increase in the price of goods or services in the US including exports. Imports to the US are not included. GDP Implicit Price Deflator closely mirrors the GDP price index. GDP Implicit Price Deflator (IPD) or GDP Deflator is a “NIPA (National Income and Products Accounts) price measure derived by dividing the current-dollar value of an aggregate or component by its corresponding chained-dollar value and then multiplying by 100. For all periods, the values of the IPD are very close to the values of the corresponding chain-type price index”. (NPA Glossary).
GDP Deflator = Nominal GDP / Real GDP
The European Central Bank uses a Harmonised Index of Consumer Prices (HICP) to calculate inflation. Harmonised means that all countries in the European Union must follow the same methodology. The ECB targets price stability with inflation of 2 percent over the medium term; inflation is one of the factors for countries joining the EU. The FED targets price stability, maximum employment, and moderate long-term interest rates. Central banks will be discussed in depth in the online course on Stabilization.
Harmonized Index of Consumer Prices composition | Image: The middle Road | Data Source Eurostat
Types of Inflation
- Headline CPI Inflation Rate
- GDP Deflation Inflation rate
- Core CPI, consensus percent CPI
- Harmonised Index of Consumer Prices
- CPIF with a fixed interest rate
Comparison of CPI [CPIAUCSL] Vs Core CPI [CPILFESL]
Data Source: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items in U.S. City Average [CPIAUCSL], Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average [CPILFESL] retrieved from FRED, Federal Reserve Bank of St. Louis;https://fred.stlouisfed.org/series/CPIAUCSL. April 16, 2022. Graph The middle Road
Time horizons targeted by various central banks include Point Estimate, Interval within a band, 1-year, Medium Term, Ongoing Core inflation is headline inflation without energy, food, and alcohol
How is the CPI market basket determined in the US ?
According to the U.S. Bureau of Labor Statistics- “CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought. There is a time lag between the expenditure survey and its use in the CPI. For example, CPI data in 2020 and 2021 was based on data collected from the Consumer Expenditure Surveys for 2017 and 2018. In each of those years, about 24,000 consumers from around the country provided information each quarter on their spending habits in the interview survey. To collect information on frequently purchased items, such as food and personal care products, another 12,000 consumers in each of these years kept diaries listing everything they bought during a 2-week period. Over the 2-year period, expenditure information came from approximately 24,000 weekly diaries and 48,000 quarterly interviews used to determine the importance, or weight, of the item categories in the CPI index structure.”
Question: Country Z produces pens and erasers. On an average 10 pens and 2 Erasers are bought every month. Assume no other product is bought. The reference year is 2017. Calculate CPI for 2019 relative to 2017. The price of the pen in 2019 is $1.05 and an eraser 0.22. The reference year is 2017. The price of a pen in 2017 was $1 and an Eraser 0.20. Calculate the increase in price relative to 2017.
2019 1.05*10+ 2*0.22 = 10.94
Real 1*10+2*0.20= 10.4
CPI=10.94/10.4=1.05
Real Vs Nominal GDP
2020 Nominal GDP = 11*1.75+ 22*1.25 = 46.7
2020 Real GDP = (11*1) + (22*1) = 11+22 = 33
Calculate Real and Nominal GDP for all the years.
Watch the education video for answers.
Next we discuss GNP