Intermediate Macroeconomic Theory I

ECON 2400

Tasso Adamopoulos
York University

Lecture 6

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 1. Measurement of Prices and Inflation

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Prices and Inflation

Price level: a measure of the general level of prices in an economy,

e.g., CPI, PPI, GDP deflator, domestic purchases deflator etc.

Denote the price level at time t by pt .

Prices increase over time. A dollar today does not buy as much as a
dollar 30 years ago.

Inflation is the proportional rate of change in the price level,

pt − pt−1
πt =
pt−1

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Aggregation Problem

How do you aggregate or summarize the prices of all goods and

services in a single index that measures the price level?

We cannot simply take the average of all the prices, because that
would imply that all goods and services are treated equally.

However, people tend to consume more milk than caviar, and as a

result we should put more weight on milk.

So we construct weighted price indices.

Type of index numbers:

I Laspeyres index
I Paasche index
I Fisher index

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Laspeyres Index
An expenditure weighted index in which the price of each good and
service receives a fixed weight equal to its share in total expenditure
in the base year.
You weigh prices by fixed quantities of goods that are the base year
quantities, and those weights to not change over time.
Laspeyres index (LI) of production or consumption,
current dollar value of base year basket
LI =
base year value of base year basket
Tells you how much it costs today to buy the basket of goods relative
to how much it costs in the base year to buy the same base year
basket of goods.
Example:
1
Q2019 1
× P2020 2
+ Q2019 2
× P2020
LI = 1 1 2 2
Q2019 × P2019 + Q2019 × P2019
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Laspeyres Index

In general the Laspeyres index overstates price increases because it

suffers from substitution bias: it does not take into account that the
basket of goods may change.

In the real world, if the price of a good increases, consumers may

substitute away from it and consume more of a close substitute →
consumers will feel less the price increase.

In the Laspeyres index (LI) the weight remains fixed to the base year.

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Paasche Index
An expenditure weighted index in which the prices of each good and
service receive a variable weight equal to its share in total expenditure
in the current year.

If expenditures on a particular good rise this year and make it a large

part of the current dollar value then that good’s weight in the price
index will rise too.

A Paasche index allows the basket of goods to change over time.

Paasche index (PI) of production or consumption,

current dollar value of current basket
PI =
base year value of current basket
Tells you how much it costs today to buy the current basket of goods
relative to how much it costs in the base year to buy the current
basket of goods.
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Paasche Index

Example:
1
Q2020 1
× P2020 2
+ Q2020 2
× P2020
PI = 1 1 2 2
Q2020 × P2019 + Q2020 × P2019
In general the Paasche index understates price increases.

The Paasche index takes substitution into account but it does not
take into account that you value less the goods towards which you
substitute (i.e., that you settle for second best), which must reduce
welfare.

Examples: fish and oil leakage; corn fields and the price of corn.

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Index Number Problem

Which is the correct index?

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Fisher Index

The Fisher index is a compromise between the Laspeyres and the

Paasche indices, given that neither is completely satisfactory.

We measure the Fisher Index (FI) as a geometric average of the other

two indices,
1
FI = (LI × PI ) 2

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Choice of base period

The problem with choosing a single period as the base period is that
if the economy goes through a dramatic change in the composition of
the goods and services produced and consumed then the index will
not be realistic. For example, is you use 1990 as the base year, there
were no smart phones.

Possible solution: construct a chained index, where for each two

adjacent periods the previous period is treated as the base period,
allowing you to take into account changes in the composition of the
basket.

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Common measures of the price level

Implicit GDP price deflator.

Consumer price index (CPI).

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Implicit GDP price deflator

Nominal GDP
Implicit GDP price deflator = × 100
Real GDP
Note: we multiply by 100 to normalize the price deflator to 100 in the
base year.

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Example on computing real GDP - Recall

Qa Pa Qo Po
Year 1 50 1.00 100 0.80
Year 2 80 1.25 120 1.60

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Nominal GDP - Recall

Nominal GDP in year 1,

GDP1 = P1a × Q1a + P1o × Q1o = 50 × 1 + 100 × 0.80 = $130.

Nominal GDP in year 2,

GDP2 = P2a × Q2a + P2o × Q2o = 80 × 1.25 + 120 × 1.60 = $292.

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Real GDP at year 1 prices - Recall

Real GDP in year 1, in year 1 prices,

RGDP11 = P1a × Q1a + P1o × Q1o = GDP1 = $130.

Real GDP in year 2, in year 1 prices,

RGDP21 = P1a × Q2a + P1o × Q2o = 80 × 1.00 + 120 × 0.80 = $176.

Gross growth rate or ratio,

RGDP21 176
g1 = 1
= = 1.354
RGDP1 130

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Real GDP at year 2 prices - Recall

Real GDP in year 1, in year 2 prices,

RGDP12 = P2a × Q1a + P2o × Q1o = 50 × 1.25 + 100 × 1.60 = $222.50.

Real GDP in year 2, in year 2 prices,

RGDP22 = P2a × Q2a + P2o × Q2o = GDP2 = $292.

Gross growth rate or ratio,

RGDP22 292
g2 = 2
= = 1.312
RGDP1 222.5

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Real GDP with the chain-weighted ratio - Recall
Once we have the Fisher ratio of real GDP in one year relative to
another, we can calculate real GDP in terms of the dollars of any year
we choose.

Real GDP in year 1 dollars:

RGDP1 = GDP1 = $130

RGDP2 = GDP1 × gc = 130 × 1.333 = $173.29

Real GDP in year 2 dollars:

RGDP2 = GDP2 = $292

GDP2 292
RGDP1 = = = $219.05
gc 1.333
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Example from Real GDP

Implicit GDP price deflator using year 1 as the base year,

GDP1
I Year 1: RGDP11
× 100 = 100
GDP2
I Year 2: RGDP21
× 100 = 165.9

Implicit GDP price deflator using year 2 as the base year,

GDP1
I Year 1: RGDP12
× 100 = 58.4
GDP2
I Year 2: RGDP22
× 100 = 100

Implicit GDP price deflator using chain-weighting,

GDP1
I Year 1: RGDP1 × 100 = 100
GDP2
I Year 2: RGDP2 × 100 = 168.5

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Example from Real GDP

Pt − Pt−1
π=
Pt−1

Inflation rate under each case:

I Year 1: π = 65.9%
I Year 2: π = 71.2%
I Chain-weighting: π = 68.5%

Note: the inflation rate depends critically on how we measure real

GDP.

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Consumer Price Index (CPI)

Cost of base year quantities at current prices

Current year CPI = × 100
Cost of base year quantities at base year prices

Note: we multiply by 100 to normalize the CPI to 100 in the base

year.

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CPI: Example from Real GDP

Using year 1 as the base year:

I Year 1 CPI = 100
RGDP12 222.5
I Year 2 CPI = RGDP11
× 100 = 130 × 100 = 171.2
I CPI inflation rate: π = 71.2%

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Differences between GDP Deflator and CPI

1 The CPI is measured as a Laspeyers Index (LI), while the GDP

deflator is measured as a Paasche (PI) or Fisher (FI) index.
2 The GDP deflator is a price index for all the final goods and services
produced in an economy, while the CPI is a price index for a set of
representative goods and services consumed in an economy (a subset
consumed by the typical household).
I Some of the goods consumed are not produced domestically but
imported. An increase in the price of Hondas made in Japan will
increase the CPI but not the GDP deflator.
I Several of the goods produced are not purchased by consumers but by
firms or government. If the price of goods purchased by firms or
government increases the GDP deflator will increase but not the CPI.

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Differences between GDP Deflator and CPI

In practice there can be substantial differences between inflation rates

calculated using the GDP deflator vs. the CPI.

They tend to move in the same direction however.

Could matter which one you use for tracking inflation, and thus
monetary policy that depends on the rate of inflation.

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Problems with measuring Real GDP and the Price Level
Relative prices change over time.
I Since the CPI keeps weights fixed it implicitly assumes that consumers
do not change their buying habits when relative prices change.
I Chain-weighting in the case of the GDP deflator helps correct for the
biases that relative price changes introduce.
I The upward bias in CPI inflation can matter for policy since some
federal transfer payments are indexed to CPI.

Changes in the quality of goods over time.

I Some of the increase in the price over time may reflect higher quality,
i.e., the buyer is receiving “more” for their money, e.g., computers
today are much faster than in the 1980s.
I Not adjusting for quality would bias growth downward and inflation
upward.

Accounting for new goods.

I How do you calculate growth in GDP and price increases when the
goods did not exist before, e.g., personal computers did not exist
before the 1980s.
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Inflation rates

In 1991 the Bank of Canada adopted the inflation rate as the

objective of monetary policy, tracking it and targeting 1-3%.
I 12-month rate of increase in the CPI (widely observable but biased
upwards).

The Bank of Canada also targets the core inflation rate, that excludes
items that tend to cause temporary changes and that tend to be more
volatile (e.g., fruit and vegetables, energy, gas etc.)

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 2. Labour Market and
Unemployment

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Labour market measurement

Labour Force Survey: monthly survey carried out by Statistics

Canada, nationwide, across a variety of demographic characteristics.

Covers population aged 15+ and not retired.

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Groups in the survey

Employed (E): those who worked part-time or full-time during the

past week.

Unemployed (U): those who were not employed during the past week;
wanted a job immediately; actively searched for work at some point
during the last 4 weeks; but could not find an acceptable job.

Not in the labour force (N): those who were neither employed, nor
unemployed, and did not want a job immediately.

Discouraged (D): those who wanted a job immediately, but had not
been looking because they thought they could not find one.

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Labour Force (LF)

LF = E + U

Includes employed and unemployed.

This is the working age population who are participating workers

(either have a job or are actively looking for one).

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Unemployment Rate (u)

U
u=
LF
The number of unemployed people as a share of the labour force.

Key statistic-indicator that macroeconomists look at from the

household survey.

Unemployment varies over the business cycle: during booms is low,

during recessions is high.

One of the key goals of macro policy is to keep it low.

Economists look at the overall unemployment rate as well as the

unemployment rates across demographic groups and regions.

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Other Labour Market Indicators

Labour Force Participation Rate (LFP),

LF
LFP =
Total working age pop. (15+)

Employment-to-population ratio,
E
EPR =
Total working age pop. (15+)

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Unemployment Rate

The unemployment rate is a stock variable.

How well does the measured unemployment rate measure true

unemployment?
I Discouraged workers.
I Part-time workers might be underemployed (if they want to work full
time).

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What does the unemployment rate meausre?

Two ways to think about it.

How close the economy is producing relative to its productive
capacity: high unemployment rate for a long period of time implies
the economy is wasting productive resources and output is below its
productive potential.

Labor market tightness: the degree of difficulty firms face in hiring

workers. Low unemployment rate implies a tight labour market , i.e.,
harder for firms to find workers.

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Labour market tightness

The unemployment rate might mismeasure labour market tightness:

1 Does not count the discouraged workers. For example, during a

prolonged recession some people that are out of work for long might
drop out of the labour force and the unemployment rate might go
down, but this does not mean that labour market tightness increased.
2 The unemployment rate does not adjust for how intensively the
unemployed are searching for work.
I High unemployment rate: the unemployed may not search hard
because they think chances of getting a job are slim.
I Low unemployment rate: the unemployed may be searching very hard
because prospects of success seem good.
I So it might be harder for firms to find workers when the unemployed
are not searching hard.

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