The main macroeconomic

variables: GDP, CPI, PPI,

Unemployment
Mr. Lutonja, E.J
Income and Expenditure
● Gross Domestic Product (GDP) measures
total income of everyone in the economy.
● GDP also measures total expenditure on the economy’s output of goods
and service.

For
For the
the economy
economy as as aa whole,
whole,
income
income equals
equals expenditure
expenditure
because
because everyevery dollar
dollar aa buyer
buyer spends
spends
is
is aa dollar
dollar of
of income
income forfor the
the seller.
seller.
2
The Circular-Flow Diagram
● D simple depiction of the macroeconomy
● illustrates GDP as spending, revenue,
factor payments, and income
● Preliminaries:
○ Factors of production are inputs like labor, land, capital, and natural
resources.
○ Factor payments are payments to the factors of production (e.g.,
wages, rent).

3
 Households:
Households:
The Circular-Flow Diagram
 own
own the
the factors
factors of
of production,
production,
sell/rent
sell/rent them
them to
to firms
firms for
for income
income
 buy
buy and
and consume
consume goodsgoods & & services
services

Firms Households

Firms:
Firms:
 buy/hire
buy/hire factors
factors of
of production,
production,

use
use them
them toto produce
produce goods
goods
and
and services
services
 sell
sell goods
goods & & services
services 4
Revenue (=GDP) Spending (=GDP)
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income (=GDP)
profit (=GDP)
5
What This Diagram Ignore?
● The government
○ collects taxes, buys g&s
● The financial system
○ matches savers’ supply of funds with borrowers’ demand for loans
● The foreign sector
○ trades g&s, financial assets, and currencies with the country’s
residents

6
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services produced
within a country
in a given period of time.
 Goods are valued at their market prices, so:
 All goods measured in the same units
(e.g., dollars in the U.S.)
 Things that don’t have a market value are
excluded, e.g., housework you do for yourself.
7
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services produced
within a country in a given period of time.
• Final goods: intended for the end user
• Intermediate goods: used as components or ingredients
in the production of other goods
• GDP only includes final goods – they already embody the
value of the intermediate goods
used in their production.

8
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services produced
within a country in a given period of time.
GDP includes tangible goods (like DVDs, mountain bikes,
beer)and intangible services (dry cleaning, concerts, cell
phone service).

9
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services produced
within a country in a given period of time.

GDP includes currently produced goods,

not goods produced in the past.

10
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services produced
within a country in a given period of time.

• GDP measures the value of production that occurs within

a country’s borders, whether done by its own citizens or
by foreigners located there.

11
Gross Domestic Product (GDP) Is…
…the market value of all final goods & services produced
within a country
in a given period of time.
Usually a year or a quarter (3 months)

12
The Components of GDP
● Recall: GDP is total spending.
● Four components:
○ Consumption (C) Y
Y =
= C
C +
+ II +
+ G
G +
+ NX
NX
○ Investment (I)
○ Government Purchases (G)
○ Net Exports (NX)
● These components add up to GDP (denoted Y):

13
Consumption (C)
● Is total spending by households on goods & service.
● Note on housing costs:
○ For renters,
consumption includes rent payments.
○ For homeowners,
consumption includes the imputed rental value of the house, but not
the purchase price or mortgage payments.

14
Investment (I)
● is total spending on goods that will be used in the future to produce more
goods.
● includes spending on
○ capital equipment (e.g., machines, tools)
○ structures (factories, office buildings, houses)
○ inventories (goods produced but not yet sold)

15
 Government Purchases (G)
● Is all spending on the goods & service purchased by govt
at the federal, state, and local levels.
● G excludes transfer payments, such as
Social Security or unemployment insurance benefits.
They are not purchases of goods & service.

Mr Lutonja, EJ 16
Net Exports (NX)
● NX = exports – imports
● Exports represent foreign spending on the economy’s goods & service.
● Imports are the portions of C, I, and G
that are spent on goods & service produced abroad.
● Adding up all the components of GDP gives:

Y
Y =
= C
C +
+ II +
+ G
G +
+ NX
NX

17
GDP and its components
In each of the following cases, determine how much GDP and each of
its components is affected (if at all).
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in Boston.
B. Sarah spends $1800 on a new laptop to use in her publishing
business. The laptop was built in China.

18
GDP and its components
In each of the following cases, determine how much GDP and each of
its components is affected (if at all).
C. Jane spends $1200 on a computer to use in her editing business.
She got last year’s model on sale for a great price from a local
manufacturer.
D. General Motors builds $500 million worth of cars,
but consumers only buy $470 million worth of them.

19
Answers
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in Boston.
Consumption and GDP rise by $200.

B. Sarah spends $1800 on a new laptop to use in her publishing business.

The laptop was built in China.
Investment rises by $1800, net exports fall
by $1800, GDP is unchanged.

20
Answers
C. Jane spends $1200 on a computer to use in her editing business. She got last year’s
model on sale for a great price from a local manufacturer.
Current GDP and investment do not change, because the computer was built last year.

D. General Motors builds $500 million worth of cars, but consumers only buy $470 million
of them.
Consumption rises by $470 million, inventory investment rises by $30 million, and GDP
rises by $500 million.

21
Real versus Nominal GDP
● Inflation can distort economic variables like GDP, so we have two
versions of GDP:
One is corrected for inflation, the other is not.
● Nominal GDP values output using current prices. It is not corrected for
inflation.
● Real GDP values output using the prices of
a base year. Real GDP is corrected for inflation.

22
EXAMPLE:
Given that:

Pizza Latte
year P Q P Q
2005 $10 400 $2.00 1000
2006 $11 500 $2.50 1100
2007 $12 600 $3.00 1200

23
SOLN:
Compute nominal GDP in each year:
Increase:
2005: $10 x 400 + $2 x 1000 = $6,000
2006: $11 x 500 + $2.50 x 1100 = $8,250 37.5%

2007: $12 x 600 + $3 x 1200 = $10,800 30.9%

24
EXAMPLE 2:
Pizza Latte
year P Q P Q
2005 $10 400 $2.00 1000
2006 $11 500 $2.50 1100
2007 $12 600 $3.00 1200

2005: $10 x 400 + $2 x 1000 = $6,000

2006: $10 x 500 + $2 x 1100 = $7,200
2007: $10 x 600 + $2 x 1200 = $8,400
25
 Pizza Latte
year P Q P Q
2005 $10$10 400 $2.00
$2.00 1000
2006 $11 500 $2.50 1100
2007 $12 600 $3.00 1200
Compute real GDP in each year,
using 2005 as the base year:
Increase:
2005: $10 x 400 + $2 x 1000 = $6,000
20.0%
2006: $10 x 500 + $2 x 1100 = $7,200
16.7%
2007: $10 x 600 + $2 x 1200 = $8,400
26
Therefore: Nominal Real
year GDP GDP
2005 $6000 $6000
2006 $8250 $7200
2007 $10,800 $8400
In each year,
● Nominal GDP is measured using the (then) current prices.
● Real GDP is measured using constant prices from the base year
(2005 in this example).

27
 Nominal Real
year GDP GDP
2005 $6000 37.5% $6000 20.0%
2006 $8250 $7200
30.9% 16.7%
2007 $10,800 $8400
● The change in nominal GDP reflects both prices and quantities.
● The change in real GDP is the amount that
GDP would change if prices were constant
(i.e., if zero inflation).
● Hence, real GDP is corrected for inflation.

28
TASK: Computing GDP
2007 (base yr) 2008 2009
P Q P Q P Q
Good A $30 900 $31 1,000 $36 1050
Good B $100 192 $102 200 $100 205

Use the above data to solve these problems:

A. Compute nominal GDP in 2007.
B. Compute real GDP in 2008.
C. Compute the GDP deflator in 2009.
29
Answers
2007 (base yr) 2008 2009
P Q P Q P Q
Good A $30 900 $31 1,000 $36 1050
Good B $100 192 $102 200 $100 205

A. Compute nominal GDP in 2007.

$30 x 900 + $100 x 192 = $46,200

B. Compute real GDP in 2008.

$30 x 1000 + $100 x 200 = $50,000
30
Answers
2007 (base yr) 2008 2009
P Q P Q P Q
Good A $30 900 $31 1,000 $36 1050
Good B $100 192 $102 200 $100 205
C. Compute the GDP deflator in 2009.
Nom GDP = $36 x 1050 + $100 x 205 = $58,300
Real GDP = $30 x 1050 + $100 x 205 = $52,000
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x ($58,300)/($52,000) = 112.1
31
GDP and Economic Well-Being
● Real GDP per capita is the main indicator of the average person’s
standard of living.
● But GDP is not a perfect measure of
well-being.
● Robert Kennedy issued a very eloquent
yet harsh criticism of GDP:

32
GDP and Economic Well-Being
“… does not allow for the health of our children, the quality of their
education, or the joy of their play. It does not include the beauty of our
poetry or the strength of our marriages, the intelligence of our public
debate or the integrity of our public officials. It measures neither our
courage, nor our wisdom, nor our devotion to our country. It measures
everything, in short, except that which makes life worthwhile, and it can
tell us everything about America except why we are proud that we are
Americans.”- Senator Robert Kennedy, 1968

33
GDP Does Not Value:
● the quality of the environment
● leisure time
● non-market activity, such as the child care
a parent provides his or her child at home
● an equitable distribution of income

34
Then Why Do We Care About GDP?
● Because a large GDP does in fact help us to lead a good life. GDP does not measure the
health of our children, but nations with larger GDP can afford better health care for their
children. GDP does not measure the beauty of our poetry, but nations with larger GDP
can afford to teach more of their citizens to read and enjoy poetry. GDP does not take
account of our intelligence, integrity, courage, wisdom, or devotion to country, but all of
these laudable attributes are easier to foster when people are less concerned about being
able to afford the material necessities of life.

● In short, GDP does not directly measure those things that make life worthwhile, but it
does measure our ability to obtain the inputs into a worthwhile life.
● Many indicators of the quality of life are positively correlated with GDP.

35
GDP DEFLATOR

36
The GDP Deflator
● The GDP deflator is a measure of the overall level of prices.
● Definition:

nominal GDP
GDP
GDP deflator 100 xx
deflator == 100
real GDP

 One way to measure the economy’s inflation

rate is to compute the percentage increase in
the GDP deflator from one year to the next.

37
EXAMPLE: Nominal Real GDP
year GDP GDP Deflator
2005 $6000 $6000 100.0
14.6%
2006 $8250 $7200 114.6
12.2%
2007 $10,800 $8400 128.6

Compute the GDP deflator in each year:

2005: 100 x (6000/6000) = 100.0

2006: 100 x (8250/7200) = 114.6

2007: 100 x (10,800/8400) = 128.6

38
CONSUMER PRICE INDEX (CPI)

39
What is CPI? - 1
● It is a measure of the average change in prices of goods and services that are commonly
purchased by households over time. The CPI is calculated by selecting a basket of goods
and services that represent what the average household buys, and then measuring the cost
of that basket over time.
● Think about a “Dollar” Scenario: A dollar today doesn’t buy as much as it did 20 years
ago. The cost of almost everything has gone up. This increase in the overall level of
prices is called inflation, and it is one of the primary concerns of economists and
policymakers.
● CPI is the most commonly used measure of the level of prices

40
41
What is CPI? - 2
● The CPI is widely used as a key indicator of inflation and is often used as a benchmark
for wage adjustments, investment decisions, and other economic policy decisions.
Governments and central banks use the CPI to track the level of price inflation and adjust
monetary policy to achieve their inflation targets.
● The CPI is calculated by taking a weighted average of prices of a basket of goods and
services commonly consumed by households.

42
Calculating CPI - 1
● Determine the base period: The base period is the period against which all other
periods will be compared. The base period typically represents a year or a period of time
when the economy is stable, and there are no significant changes in the prices of goods
and services.
● Select the basket of goods and services: The basket of goods and services should
represent the average spending pattern of households. The basket should include goods
and services that households purchase regularly, such as food, housing, transportation,
medical care, and entertainment.

43
Calculating CPI - 2
● Determine the prices of goods and services in the basket: Collect price data for each
item in the basket for the current period. The prices should be for identical goods and
services sold at different locations and times.
● Calculate the total cost of the basket: Multiply the quantity of each item in the basket
by its corresponding price and add up all the values. This will give you the total cost of
the basket.
● Repeat the above steps for the base period: Collect price and quantity data for each
item in the basket for the base period.

44
Calculating CPI - 3
● Calculate the CPI: Divide the total cost of the basket in the current period by the total
cost of the basket in the base period. Multiply the result by 100 to get the CPI.

CPI = (Total cost of basket in current period / Total cost of basket in base period) x 100

● Interpret the results: A CPI value greater than 100 indicates that prices have increased
compared to the base period, while a CPI value less than 100 indicates that prices have
decreased compared to the base period.

45
CPI - Example
● Consider the data below and calculate CPI

Price in Base Year Price in Current

Item Quantity
(2012) Year (2021)

Maize 100 $15 $20

Corn 50 $17 $21
Bread 50 $10 $10
Wheat 150 $7 $12
Clothes 25 $19 $24

46
CPI - Example
● Solution

47
Uses/Application of CPI - 1
● Measure of inflation: The CPI is primarily used to measure changes in the overall level
of prices in the economy over time. When the CPI rises, it indicates that prices are
increasing, and when it falls, it indicates that prices are decreasing. This information is
important for policymakers, businesses, and consumers who want to understand how the
economy is performing.
● Wage adjustment: The CPI is often used as a basis for adjusting wages, salaries, and
pensions to account for inflation. Collective bargaining agreements, labor contracts, and
government programs may include provisions for automatic adjustments to wages and
benefits based on changes in the CPI.

48
Uses/Application of CPI - 2
● Fiscal policy: The CPI can be used as a guide for fiscal policy, which is the use of
government spending and taxation to influence the economy. For example, if the CPI is
rising rapidly, policymakers may consider increasing taxes or reducing government
spending to cool off the economy and prevent inflation from getting out of control.
● Monetary policy: The CPI is also used as a guide for monetary policy, which is the use
of interest rates and the money supply to influence the economy. The Federal Reserve for
example, which is the central bank of the United States, uses the CPI to help determine
its target for the federal funds rate (discount rate in TZA), which is the interest rate that
banks charge each other for overnight loans.

49
Uses/Application of CPI - 3
● Cost-of-living adjustments: The CPI is used to calculate cost-of-living adjustments
(COLAs) for certain government programs and benefits. For example, Social Security
benefits are adjusted annually based on changes in the CPI to help maintain the
purchasing power of retirees' incomes.

50
Limitations of using CPI - 1
● Three common limitations are substitution bias, new goods bias and quality adjustment.
○ Substitution bias arises because the CPI basket of goods and services is fixed,
which means that it does not account for consumers' ability to substitute between
goods and services as prices change. In other words, when the price of a good in the
CPI basket increases, consumers may switch to a cheaper alternative that is not
included in the basket. As a result, the CPI may overstate the true increase in the cost
of living for consumers.

51
Limitations of using CPI - 2
● Three common limitations are substitution bias, new goods bias and quality adjustment.
○ New goods bias arises because the CPI basket is updated infrequently, which means
that it does not account for new products or technologies that become available over
time. When new products or technologies are introduced, they may be more efficient
or less expensive than existing products, and consumers may switch to them.
However, if these new products are not included in the CPI basket, the CPI may
overstate the true increase in the cost of living for consumers.

52
Limitations of using CPI - 3
● Three common limitations are substitution bias, new goods bias and quality adjustment.
○ Quality adjustment: The CPI attempts to account for changes in the quality of
goods and services over time, but this can be difficult to do accurately. If quality
improvements are not fully reflected in the CPI, this can lead to an overstatement of
inflation.

53
CPI vs GDP Deflator
● Two common limitations are substitution bias and new goods bias.
○ New goods bias arises because the CPI basket is updated infrequently, which means
that it does not account for new products or technologies that become available over
time. When new products or technologies are introduced, they may be more efficient
or less expensive than existing products, and consumers may switch to them.
However, if these new products are not included in the CPI basket, the CPI may
overstate the true increase in the cost of living for consumers.

54
PRODUCER PRICE INDEX (PPI)

55
What is PPI?
● PPI is a measure of the average change in prices received by domestic producers for their
output.
● In other hand, PPI measures the rate of change in the prices of products sold by
producers over a period of time.
● It measures price changes from the perspective of the seller rather than the consumer,
which makes it a useful tool for analyzing inflation at the production level.
● PPI covers a wide range of goods and services, including raw materials, intermediate
goods, and finished goods. The prices included in the index are weighted according to
their relative importance in the production process.

56
57
PPI Continued
● Unlike the consumer price index (CPI), the product prices in PPI do not include any
taxes, trade, or transport margins that buyers have to pay.
● Instead, PPI prices reflect the changes in production costs. However, these changes
eventually get passed on to consumers and are reflected in CPI.
● Thus, both PPI and CPI are popular measures of inflation. The US Bureau of Labor
Statistics (BLS) for example, publishes the PPI figures at regular intervals based on the
data from industries operating in the goods-manufacturing sector.

58
Classification of prices in PPI - 1
● PPI classifies the price changes based on three broad structures – Industry-level
classification, Commodity classification, and Final Demand – Intermediate Demand (FD-
ID).
○ The industry-level PPI classification is done with respect to the changes in the
total net output of an industry. This net output marks the aggregate sales price of
products produced in an industry that is sold outside that sector.
○ Commodity classification refers to the categorization done on the basis of the
products and services. PPI identifies and segregates products of an industry
depending on the overall similarity, composition, and use.

59
Classification of prices in PPI - 2
● PPI classifies the price changes based on three broad structures – Industry-level
classification, Commodity classification, and Final Demand – Intermediate Demand (FD-
ID).
○ FD-ID classification is based on the end-user of the products and services. PPI
classifies the price change as a final demand if the end-users are the customers
themselves. On the other hand, when the products and services reach customers
through channels in between, the price changes are categorized as intermediate
demand.

60
Calculating PPI - 1
● Major formula
○ PPI = Current price of basket/Base price of basket
○ Where, Basket is the relative weight of goods and services in the current or base
period.
● Laspeyres Formula
○ This PPI formula weighs goods in proportion to their quantities in the base year.

○ Where, q0 = quantity in the base period, p0 = price of the product in the base period,
pt = price of the product in the current year

61
Calculating PPI - Example
● Here is a producer price index example to understand the calculation in a better way.
calculate the PPI for the year 2020 based on the price changes recorded in the chart
below by using Laspeyres formula:

Quantity in Quantity in Price in 2010 Price in 2020

2010 (q0) 2020 (p0) (pt)

15 10 10 8
40 35 15 20
20 22 15 20

62
Calculating PPI - 3
● Laspeyres Formula

● 125.7

● = 100
● The PPI for the base year 2010 is 100, increasing to 125.7 in 2020. Thus, it shows that
prices have risen from 100 to 127.5 in a span of 10 years.

63
Uses/Application of PPI - 1
● Used as a contract adjustment tool to put relevant adjustment clauses to long-term
contracts, considering the percentage of price changes
● Best parameter to compare the input and output price difference
● Indicator of inflation at the producers’ levels
● A measure of inflation for particular industries or commodities
● Helps measure the real growth of an economy recorded as the Gross Domestic
Product (GDP) and distinguish it from the nominal growth

64
CPI vs PPI vs GDP DEFLATOR

65
CPI vs PPI vs GDP DEFLATOR - 1
Criteria CPI PPI GDP Deflator
A measure of the price
A measure of the
A measure of the changes of all new,
average price
average price of goods domestically
Definition received by domestic
and services purchased produced, final goods
producers for their
by households and services in an
output
economy

66
CPI vs PPI vs GDP DEFLATOR - 1
Criteria CPI PPI GDP Deflator

Measures the price Measures the price Measures the price

changes of a basket of changes of inputs changes of all final
Coverage goods and services used in the goods and services
typically purchased by production process of produced within the
households goods and services borders of a country

67
CPI vs PPI vs GDP DEFLATOR - 1
Criteria CPI PPI GDP Deflator

Measures inflation as Measures inflation as Measures inflation as

Purpose experienced by experienced by experienced by the
households producers entire economy

68
CPI vs PPI vs GDP DEFLATOR - 1
Criteria CPI PPI GDP Deflator

Based on the weighted Based on the

Based on the ratio of
average of prices of a weighted average of
Calculation nominal GDP to real
basket of goods and prices of inputs used
GDP
services in production

69
CPI vs PPI vs GDP DEFLATOR - 1
Criteria CPI PPI GDP Deflator

Typically measured Typically measured Typically measured

Time frame
monthly or quarterly monthly or quarterly annually

70
CPI vs PPI vs GDP DEFLATOR - 1
Criteria CPI PPI GDP Deflator

Useful for consumers, Useful for businesses Useful for analyzing

policymakers, and to track changes in changes in overall
Usefulness economists to monitor input costs and to set economic activity and
changes in the cost of prices for their for measuring
living products inflation

71