Macroeconomics - Lecture Notes
BEGIN MIDTERM 1
Week 1: 1.1-1.2
scarcity - the limited nature of society’s resources
macroeconomics - study of behavior and performance of an economy as a whole
fiscal policy - government spending
monetary policy - enacted by central bank (FED)
when FED lowers interest rate, saving becomes less attractive, consumption increases, GDP increases
The business cycle implies recession and recovery
Inflation increases = Value of money decreases
RECAP OF MICRO
market - group of buyers or sellers that interact
price dictates how much to produce
quantity dictates how much to sell or buy
demand - there’s people who want to buy a product
law of demand - price and quantity demanded are inversely proportional **DOWNWARD SLOPING
supply - there’s people who want to provide/sell a product
the law of supply - price and quantity are directly proportional **UPWARD SLOPING
INSERT NOTABILITY GRAPH X2
GROSS DOMESTIC PRODUCT
gold/silver - accumulation of wealth
money - medium of exchange
you cannot just print as much money as you want
output (production) - how much a country can produce
The Great Depression 1930s
kuznet - created the first quantitative measure of economic health
GDP measures how much is being made in a country
total income - income of every citizen in the country
total expenditure - the economy’s sum of spending on goods and services
ex. income - why? every dollar spent by consumer is a dollar of income for seller
GDP - the market value of all final foods and services produced within a country in a given period of time
“market value” - actual market for the goods and services, all goods measured in same units (dollars)
goods and services with no markets are not included (ex. chores at home you do for yourself, illegal activities are done outside of the market)
“all final goods and services” - ex. playing cards
intermediate goods - the paper to make the card
final goods - the card itself
when you go to the store to buy the card you don’t sit there trying to figure out the price of paper (intermediate good), you consider the price of the card deck alone as a whole (final goods)
“produced” - only goods and services produced by economy are counted; doesn’t matter if goods are bought, sold, consumed, traded, etc.
ex. transactions of a used car in 1994 are not used to calculate the GDP in 2024
“within a country” - only measures of value of production that occur within a country’s borders, whether done by its own citizens or by foreigners located there
even though BMW is owned by Germany, the production of their card in factories within the US is part of the USA’s GDP
“in a given period of time” - typically a year or quarter; does not include goods produced in the past
COMPONENTS OF GDP
Consumption - total spending by households on goods and services
Regarding housing costs…
for renters, consumption includes rent payments
for homeowners, consumption includes the imputed rental value of the house, but not the purchases of new housing or mortgage
“imputed rental value” - how much you actually have to pay when you rent
the owner is renting a house to himself
Investment - total spending on goods that will be used in the future to produce more goods
business, residential, and changes in investment
includes spending on
capital equipment (machines, tools, etc)
structures (factories, office buildings, houses)
when you purchase new house, mortgage is not included in the GDP because there is nothing produced, just a transfer of money to the bank to pay back a transaction already made
inventories (goods produced but not yet sold)
ex. Dell makes 1000 computers and sells 900 in 2024, 100 computers are left in their inventory which is their investment spending
if they sell the 100 computers in 2025, then what was inventory in 2024 is consumption in 2025
Government expenditure - all spending on the goods and services purchased by government at the federal, state, and local levels
ex. salaries of govt employees, contracts to build new roads and bridges, military spending
does not include transfer payments
transfer payments - made by govt to households and firms that are not in exchange for a good or service
ex. unemployment insurance, medicare, social security, etc
Net Exports
net exports = exports - imports
export - goods and services produced in the US but bought and consumed internationally
import - goods and services produced internationally but bought and consumed in the US
ex) buy bottle of wine from Argentina for $20
GDP = Y = C + I + G + (EX - IM)
Week 2
2.1
• GNP = GDP any income earned by residents from overseas - income earned by foreigners
• Ferrari opened a factory in SF
◦ value of company cars produced by italian citizens and the equipment they own is
‣ C. Italian GNP and U.S. GDP
• Percentage Change = ((this year gdp - last year gdp)/last year gdp) * 100
• GDP measures price and quantities
• GDP increases from one year to the next because
◦ 1) Price increase
‣ not economic growth (Price Increase = GDP Increase)
◦ 2) Production increase (Quanitity Increase = GDP Increase)
‣ real economic growth
• True economic growth is seen in the amount of goods that can be produced every year
• Nominal GDP = current price * current quantities
◦ Nominal GDP measures everything in terms of today
• Real GDP = base year price * current quanitities
◦ Real GDP measures the market value of production using a base year's prices
◦ changes in production only
Real GDP is an indicator to measure the health of the economy
Nominal GDP uses the current price, Real GDP uses base year price (constant price)
Change in nominal GDP reflects price AND quantity
Change in real GDP is amount that Y changes if prices were constant
Real GDP is corrected for inflation; it strips out price increase and only shows changes in Y at constant prices
In a graph, the real and nominal GDP intersect at the base year
GDP Deflator - measure of the overall price level in the economy
GDP Deflator = (nominal GDP/real GDP) * 100
ALWAYS 100 IN BASE YEAR
Real GDP is the denominator because it is the standard or foundation needed to know how much the price has changed
Inflation rate = ((GDP deflator today - GDP deflator last year)/GDP deflator last year) * 100
Real GDP per capita = Real GDP / # of population
ex) THINK! people got sick during covid causing an increase in the number of patients, medical expenses, consumption increase overall, thus a GDP increase
Did standard of living increase? Answer: NO
As people’s health status declines, it causes a dissatisfaction
Limitations of GDP
GDP is not a perfect measure of well being
increase operation of factories causes increase in inventory causes increase in GDP but decline of good air quality
2.2
GDP Per Person = Real GDP / # of population
Productivity
Y = real GDP = output = production
L = labor
Y/L = output per labor/worker = productivity = avg labor productivity
As productivity increases, income increases, living standards increase
4 Determinants of productivity
1) Physical Capital Per Worker - the stock of equipment and structures to produce g&s
denoted by K
includes stocks of equipment, machines, and structures
K/L increase = Y/L increase
2) Human Capital Per Worker - the knowledge and skills workers acquire through education, training and experience
denoted by H
H/L increase = Y/L increase
3) Natural Resources Per Worker - the inputs into production that nature provides (land, minerals, etc)
denoted by N
N/L increase = Y/L increase
4) Technological Capital Per WOrker Society’s understanding of the best ways to produce goods and services
denoted by A
A is used bc of Solow Swan Model (1950s)
ex. Henry Ford’s assembly line allowed boom in productivity for the auto industry and country as a whole
Promoting Technological Progress
number of geniuses increase = productivity increase
Some argue world’s population growth is depeleting Earth’s natural resources and will limit living standards
Human capital per worker can be viewed as avg skill level of workers within economy
increasing human capital mans increasing/investing in:
education
public education is heavily invested in by govt to boost societal productivity
health/nutrition
worker training and programs
diversity inclusion training
Investment spending - spending by firms to purchase physical capital
K/L increase = Y/L increase
Savings and Investments go hand in hand
savings increase = investment increase = K increase = Y
Investments may come from abroad
Two types of foreign investment
FDI - Foreign Direct Investment; capital is owned and operated by a foreign entity
ex. BMW is German but built factories in the US
FPI - Foreign Portfolio Investment; capital investment financed with foreign money but operated by domestic residents
ex. BMW invests in Microsoft stock
Foreign investment is beneficial in poor countries that cannot generate enough savings to fund investments
Diminishing returns to physical capital
As capital stock per worker increases, each additional piece of capital provides a smaller amount of benefit
increasing capital stock increases productivity, but it’s not constant
Catch-Up Effect - poor economies will grow faster than wealthier economies
ex. 1960-1990, US and Korea devoted a similar share of GDP to investment, much Korea grew over 6% while US grew 2%
RECAP/MAIN TAKEAWAY
Higher saving rate
implies a higher productivity (Y/L) - “level of economy”
does NOT imply higher productivity (Y/L) growth due to diminishing returns
Increase in Technological Knowledge
Main reason standard of living rises over long run - technological progress
Policy to promote technological progress
patent laws
tax incentives or direct support for private sector R&D
Grants for basic research
Week 3
3.1
Exchange Rate
Scenario: Imagine you are visiting Machu Pichu, Peru which uses Peruvian Nueva Sol currency. You go to the bank, the bank converts your dollars via foreign exchange market.
$1 = 3.7 sol
$1,000 = 3.7 × 1000
Nominal Exchange Rate - the value of one country’s currency in terms of another country’s currency
determines how many units in foreign currency you can purchase with $1
ex. $1 = 0.9 euros
To find the value of a euro, divide the value you have in dollars by the value of $1 in euros
ex. What’s the value of a bottle ofo ale that costs 3 euros?
$1 = 0.9 euros
3/0.9 = $3.33
Appreciation - strengthening; an increase in market value of one currency relative to another currency
Depreciation - weakening; a decrease in the market value of one currency relative to another currency
ex) $1 = $80 Yen —> $1 = $90 Yen
You can buy more Yen with $1, thus the value is appreciating
ex) $1 = $80 Yen —> $1 = $70 Yen
You can buy less Yen with $1, thus it is depreciating
Real Exchange Rate - rate at which the g&s of one country trades for the g&s of another (R)
Formula: R = e * p / p*
R - real exchange rate
e - nominal exchange rate
p - domestic price
p* - foreign price
ex) Swiss cheese is twice expensive than American Cheese. The real exchange rate is ½ lb of swiss cheese per lb of American cheese.
if R > 1, price in numerator country is more expensive
if R < 1, price in denominator country is more expensive
if R = 1, price is the same in both countries
ex 1) latte in new york is $4.30. latte in japan is 550 yen
R = 154×4.3 / 550 = 1.204
1.204 >1
Thus, the price of Yen of domestic price is more expensive than foreign price.
ex 2) big mac costs $2.50 in US, 400 yen in Japan. Nominal exchange is 120 yen per $1.
R = 20 × 2.50 / 400 = 300 / 400 = 0.75
R = 0.75 < 1
Thus, the price of Yen of domestic price is less expensive than foreign price, or, Big Mac is cheaper in the US than Japan.
ex) e = 10 pesos per $. price of tall starbucks latte is P = $3 and P* = 24 pesos in Mexico.
A) Price of US latte measure in pesos?
e * p = 10 × 3 = 30 pesos per latte
B) Real exchange rate, measures as Mexican lattes per US latte?
30 / 24 = 1.25
1.25 > 1
Thus, latte in the US is more expensive than a latte in Mexico
Why does R matter?
e tells you how the currencies trade
R for trade (export or import)
Exchange Rate in Relation to Foreign Goods
P = US price level
P* = foreign price level
Real exchange rate = e * P / P*
^^this is the price of a domestic basket of goods relative to price of a foreign basket of goods
If US R appreciates, US gas becomes more expensive relative to foreign goods
EX decreases, IM increases —> NX decreases
If US R appreciates, US gas becomes cheaper relative to foreign goods
EX increases, IM decreases —> NX increases
Law of One Price - notion that a good should sell for the same price in all markets
ex) Coffee is $4 lb in Seattle and $5 lb in Boston and can be costlessly transported.
A coffee shop buys coffee in Seattle and sells it in Boston. Thus generating a $1 profit. This is called arbitrate.
Arbitrate - selling the same product in different places and making more profit.
Such arbitrate drives up price in Seattle, but drives down price in Boston
In the end, the $ must buy the same amount of coffee in all states/countries by the law of one price.
Purchasing Power Parity (PPP) - theory that in the long run exchange rates move to equalize the purchasing power of different currencies
based on law of one price
currency must have same purchasing power in all countries
PPP implies that nominal exchange rate between 2 countries should equal the ratio of the price levels
ex) if inflation is higher in Mexico than US, p* rises faster than P
e rises, thus the $ appreciates against the peso
ex) if inflation is higher in US than Mexico, P rises faster than p*
e falls, thus the $ depreciates against the peso
3.2
Net Export
1 of 10 economic principles: Trade can make everyone better off
closed economy - does not interact with other economies in the world
open economy - interacts freely with other economies around the world
NX = EX - IM is not equal to 0 OR NX = 0(EX = IM)
1) Product Market - buy and sell goods and services (g&s)
2) Financial Market - Buy and sell capital assets (ex. bonds or stocks)
Recession - downturn in economy (decline in economic activity)
Y decreases → stop hiring or layoff → unemployment
What would happen to US NX if,
Canada experiences a recession (Falling incomes, rising unemployment)
Answer: NX will decrease
Canadian consumers’ purchases of US g&s decreases, export decreases, thus NX decreases
US consumer decide to be patriotic and buy more products “Made in the USA”
Answer: NX increases
Prices of goods produced in Mexico rise faster than prices of goods produced in the US
Answer: NX increases
Variables Influencing NX include…
Consumer preferences of foreign and domestic goods
prices of goods domestic and abroad
incomes of consumers domestic and abroad
exchange rates
transportation costs
government policies
NX measures the imbalance in a country’s trade in goods and services
Trade deficit - an excess of imports over exports; IM > EX → NX < 0 (NX is negative)
Trade surplus - an excess of exports over imports; IM < EX → NX > 0 (NX is positive)
Balanced trade - when exports = imports
Net Capital Outflow (NCO)
Net capital outflow - domestic residents’ purchases of foreign assets - foreigners’ purchases of domestic assets
“domestic residents’ purchases of foreign assets” - ex. US residents buy stocks in Toyota
“foreigners’ purchases of domestic assets” - ex. Mexican residents buy stocks in Ford
AKA Net Foreign Investment
2 Forms:
Foreign direct investment - domestic residents actively manage the foreign investment
ex. BMW opens factories in CA
Foreign portfolio investment - domestic residents purchase foreign stocks/bonds, supplying loanable funds to a foreign firm
capital outflow: NCO > 0
domestic purchases of foreign assets exceed foreign purchases of domestic assets
capital inflow: NCO < 0
foreign purchases of domestic assets exceed domestic purchases of foreign assets
NX (Net Exports) = NCO (Net Capital Outflow)
This is an accounting identity that arises because every transaction that affects NX also affects NCO by the same amount (and vice versa)
ex. PS5’s are Sony made and Sony is a Japanese company. As Japan imports the consoles to the US, the US NX decreases. The consoles are purchased in the US in dollars and used in Japan in their own currency. Japan uses the money to buy stocks in US companies. Thus, US NCO decreases. As time goes on, the NX and NCO come to equalize.
When a foreigner purchases a good from the US
US EX increases → NX increases (Trade Surplus)
US acquires some foreign assets → NCO increases
When a US citizen buys foreign goods
US IM increases → NX decreases (Trade deficits
NCO decreases
Savings - A vehicle for transferring purchasing power to the future
Investment - Purchases of a new capital (such as equipment building), borrowing to finance those purchases
CH 12: S increases = I increases → K/L increases, Y/L increases
National Income Account Identity - used to determine how important macroeconomic indicators are related to each other
formula: Y = C + I + G + NX
Identity - an equation that must be true because of the way the variables in the equation are defined
Private Saving = Y - T - C
T is Tax
Leftover income a household has after spending their money on C and paying taxes
Public Saving = T - G
leftover tax revenue the government (G) has after paying for all its spending
The government’s budget - how much money they are allowed to spend on purchasing in a given year
The government’s budget balance - determined by whether they spend more or less than they take in that year
Government’s “income” is tax revenue
when govt spends more than they collect in tax revenue, they run a budget deficit
Public saving < 0 → T - G < 0 → T < G (G - T)
when the govt spends less than they collect in tax revenue, they run a budget surplus
Public saving > 0 → T - G > 0 → T > G (T - G)
BEGIN MIDTERM 2
Week 4 - 4.1
For the economy all together: Savings = Investment
Loanable Fund - Income that people have chosen to save and lend out, rather than use for their own consumption, and to the amount that investors have chosen to borrow ti fund new investment projects
Assume one financial market called the market for loanable funds
All savers go to this market to deposit their saving
All borrowers (investors) go to this market to take out their loans
***REAL INTEREST RATES FOR THE REST OF THE CHAPTER
Supply of Loanable Funds
Comes from people who save extra income they want to save and lend out
Saving is source of supply for loanable funds
Demand of Loanable Funds
comes from households and firms who wish to borrow to make investments to purchase capital goods
Investment is the source of demand for loanable funds
Equilibrium of Loanable Funds
when savings and investments are equal
Changes in Saving and Investment Behavior
1) Policy shifts the supply or demand curve
Saving incentives are designed to encourage people to save more
Reduce taxes burden
Decreasing risk / financial safety nets
2) Determine the direction of the shift (does the demand curve shift up or down?)
3) See how equilibrium changes (initial eq → eq now)
Week 4.2 - Midterm
Week 5 - 5.1
Fiscal Policy (T or G) - form of govt spending
1) Expansionary Fiscal Policy
Government Spending Increases
Taxes Decrease
Both increase in G or decrease in T stimulate economic growth
2) Contractionary Fiscal Policy
G decreases
T increases
both decrease in G and increase in T slow down overheating or curb inflation
Rest of the notes on notability (see on Canvas)
5.2
graphs on notability
Week 6 - 6.1
**CHECK CANVAS FOR THIS LECTURE FOR LOTS OF VISUAL DEPICTIONS
Barter Economy - economies in which goods and services are traded directly for other goods and services
Money - assets that people are generally willing to accept in exchange for goods and services or for payment of debts
Commodity Money - Take the form of a commodity with intrinsic value
ex. gold coins, cigarettes
Fiat Money - money without intrinsic value (used as money bc of govt. decree)
ex. the US dollar
medium of exchange - money serves as a medium of exchange when sellers are willing to accept it in exchange for g&s
unit of account - the yardstick people use to post prices and record debts
measure and record economic values
store of value - an item people can use to transfer purchasing power from the present to the future
financial system - the group of institutions that helps match the saving of one person with the investment of another
financial system made up of two categories of financial institutions:
1) financial markets - institutions through which savers can directly provide funds to borrowers
a) bond market - a bong is a certificate of indebtness
IOU is issued and est. to mature for a set amount of time
b) stock market - a stock is a claim to partial ownership in a firm
buying a stock makes you a shareholder - you’re buying a “share” or a PART of the company
dividends - the profits of the company shared to the shareholders
2) financial intermediaries - institutions via which savers can indirectly provide funds to borrowers
a) banks - roles include taking deposits and creating loans, and increasing money supply (SEE MORE IN SEPARATE SECTION BELOW)
people sign up for a bank account (savers)
the bank outputs money to investors
investors put money into the bank
bank outputs money to savers
b) mutual funds - institutions that sell shares to the public and use the proceeds to buy the portfolios of stocks and bonds
Bitcoin - a type of online “cryptocurrency” people can buy and sell in exchange for physical currency
Money Supply - quantity of money available in economy (currency + demand deposit)
currency - coins, paper bills
demand deposit - balance in bank account that depositors can access when they want by writing check or swiping credit card
banks hold demand deposits, banks are in charge of increasing increasing money supply
Central Bank - institutions that oversees banking system and decides monetary policy
Monetary policy - setting of money supply by policymakers in central bank
Federal Reserve (FED) - central bank of the US
Made up of 2 parts:
Board of Governors - in DC, 7 members appointed for 14 yrs, Most important member is chairman appointed for 4 years
Federal Open Market Committee (FOMC) - 12 regional banks located around US, meets every 6 weeks with the Board and regional FED presidents
Jobs Include
1) Regulate banks and ensure health of the banking system; “the banks bank”
2) Control quantity of money (money supply) to create the monetary policy
The Role of the Bank: Deep Dive
1) To accept deposits from consumers
Deposits are typically the banks largest liability
that is, into a checking or savings account
Banks are owed to the household/firms that households/firms have deposited their funds
if people haven’t deposited, the bank has no money to give
2) To make loans to households and firms
Loans are a typical bank asset
if people haven’t paid back their loan, interest accumulates for their profit
Do Banks Create Money?
ex. you have $100 in currency. you decide to put it into a checking account at First National Bank (FNB).
FNB’s Financial Statement consists of Assets and Liabilities (see notes for t-bar); Assume FNB put all deposits in vault to not loan out
Assets
Reserves: $100
Loans: $0
Liabilities
Deposits: $100
**Assets and Liabilities should always be equal
100% Banking system - banks hold 100% of deposits as reserves, make no loans
these banks DO NOT affect size of money supply
money supply (MS) = Currency + Demand Deposit
Before FNB opens, I only hold $100 in currency, thus
money supply = $100 + $0 = $100
After deposit,
money supply = $0 + $100 = $100
fractional reserve banking system - banks keep a fraction of deposits as reserves and use the rest to make loans
the FED establishes reserve requirements
The Reserve Ratio (R)
= fraction of deposits banks hold as reserves
= total reserves as a percentage of total deposits
R = Reserve/Deposits
Hold reserves GO BAAAAAAAACK
SIDE NOTE/ADVICE ON INVESTING
bonds are safe to invest in as far as securing your return
bonds are sold as traders and investors consider the price of bonds and yield (interest) rates
attractive for price of bonds and yield right to have an INVERSE relationship
ex. take a used car, you bought it for 30k with 50 mpg. after a week, a new car looks exactly like your car but has 80mpg. now no one wants to buy your car, thus depreciating the value of your car to 10-20k.
6.2
CATCH UP - NOTES ON CANVAS
Week 7
7.1
Employed (E) - people who currently have a job
can be paid, unpaid, or self-employed
Unemployed (U) - people not working who were available for work
specifically, have attempted to find a job in the past 4 weeks
Not in the Labor Force - neither employed or unemployed
ex. students, homemakers, retirees, disabled
Market Stats
Labor force - total number of workers (employed AND unemployed)
Labor Force = E + U
Labor Force Participation rate - % of total adult population that is in labor force
Labor Force Participation Rate = ( (E+U) / Adult Population) * 100
Unemployment - Percentage of the labor force that is unemployed
Unemployment Rate = (U / (E + U)) * 100
Ex. In each of the following what happens to unemployment?
a) Sue lost her job and begins looking for a new one
Answer: U rate rises → labor market worsens
b) John, a steelworker who has been out of work since his mill closed laste year, becomes discourages and gives up looking for work.
Answer:
“Discouraged workers” - would like to work but have given up looking for jobs; classified as NOT in labor force, not “unemployed”
ex. U = 10, E = 90
U rate is 10%
Discouraged workers 5, U = 5, E = 90, U rate about 5.26%
Unemployment rate is not a perfect indicator of joblessness or health of labor market
excludes discouraged workers
does not distinguish between full and part time
some people misreport their work status in survey
Congressional Budget Office calculates average level of unemployment
Cyclical unemployment - deviation from its natural rate of unemployment
dependent on length of recession (temporary)
ex. 2007-2009 financial crisis
Home builders stopped constructing new homes → many construction workers lost their jobs
Natural rate of unemployment - long-run average rate of unemployment(smooth, red line in graph)
Natural Unemployment is made of 2 parts
Frictional unemployment
takes time to search for jobs
occurs when no jobs are available
Structural unemployment
When wage is above equilibrium, not enough jobs
due to minimum wages, labor unions, efficiency wages
7.2
CATCH UPPP
Unions - protect workers’ rights from a worker association
Bargaining to receive HIGHER wages and better benefits
When unions raise wage above eq, labor quantity demanded falls and unemployment occurs
Insiders - workers who remain employed are better off
Outsiders - workers who lose their jobs
Critics of Unions
that they’re a type of cartel
inefficient allocation of labor
Advocates of Unions
That they’re necessary to combat the power of large firms and industries
Without unions, firms would pay less and offer worse working conditions
Efficiency wages - wages set above equilibrium by firms in order to boost worker productivity
Goals: Increase worker health, quality and effort; reduce employee turnover
By increasing wages
1) workers can afford better diets → increase worker health → increase productivity
2) Firms attract higher quality applicants
3) Firms retain worker longer (reduce turnover)
higher wage is incentive to refrain from switching companies
training employees takes time and money saved in offering higher wages
Firms/employers want to pay more to pay better workers
ex. Henry Ford
was $5 cut down to $2.5 as “best way to cut cost”
Business Cycle of the Economy
Expansion
consumption increases
investment increases (firms aiming to produce more)
Output Y increases
Job availability increases
Employment increases
Peak
Real GDP per capita dips below 2% continuing to decline
Consumption reduces → Business sales and profits declines
Stock prices decrease → overall market activity declines
Contraction/Recession
if contraction continues for two consecutive quarters, it’s RECESSION
Decline in economic activity
Y decreases
Layoff increases → unemployment increases
The layoff of employees reduces employee overall spending due to income decrease
Contraction/Depression - prolonged recession
consumers duffer
high unemployment
Trough - prolonged depression
inflation rate falls
interest rate falls
Recovery
Interest rate declines making firms and households borrow to finance spending
Improves business activity → hiring increases again
Week 8
8.1
consumer price index (CPI) - measures the typical consumer’s cost of living
used an an economic indicator
used to determine govt economic policy
used as means of adjusting income
COLAs - cost of living adjustments
Personal inflation may differ depending on your personal habits
Problems with CPI include
Substitution Bias
People naturally switch to cheaper goods when prices of other goods rise
Introduction of New Goods
Using a fixed basket makes it difficult to determine the impact of new goods on the market
Unmeasured Quality Change
It is difficult to measure and value quality changes within a product over time
Week 9
Problems with CPI (it does not account for…)
1) substitution bias - consumers substitute towards goods that become relatively cheaper, mitigating effects of price increases
over time some prices rise faster than others
CPI misses this substitution
2) introduction to new goods - as new products are introduced, it is more likely that you will find one that more closely matches your preferences
it makes you de facto better off
it increases variety and SET of possible choices
3) unmeasured quality change -
CPI vs. GDP deflator
GDP deflator measure different sets of goods
Y = C + I + G + NX = C + I + G + EX - IM
GDP
reflects the proces of all goods and services produced domestically
does not include prices of imports
includes prices of investment goods
CPI
reflects the price of all good and services bought by consumers
does not include price of imports
does not include prices of investment goods
Usefulness of CPI
LA dodger salary 240K in 1990s, yet 1M or so present-day. CPI helps account for change in value
Correcting Prices over time
REVIEW EXAMPLE ON CANVAS
amount in today’s price = amount in other years price * (price level today / price level other year)
Week 10