GDP_CPI and Inflation

PowerPoint Presentations for
Principles of Macroeconomics
Eighth Canadian Edition
by Mankiw/Kneebone/McKenzie
Adapted for the

Eighth Canadian Edition by
Marc Prud’Homme
University of Ottawa
5-1
Copyright © 2020 by Nelson Education Ltd.
MEASURING A
NATION’S INCOME
Chapter 5
Copyright © 2020 by Nelson Education Ltd. 5-2

MEASURING A NATION’S INCOME
 Microeconomics: the study of how households and firms
make decisions and how they interact in markets.
 Macroeconomics: the study of economy-wide phenomena,
including inflation, unemployment, and economic growth.

MEASURING A NATION’S INCOME
 Gross domestic product (GDP) measures the total
income of a nation.
 Because it is thought to be the best single measure of a
society’s economic well-being, it is the most closely
watched economic statistic.

THE ECONOMY’S INCOME AND EXPENDITURE
For an economy as a whole,

income must equal expenditure.

FIGURE 5.1
The Circular-Flow
Diagram

Quick
Quiz
What two things does gross domestic product

measure?
How can it measure two things at once?

THE MEASUREMENT OF
GROSS DOMESTIC PRODUCT
 Gross domestic product (GDP): the market value of all final
goods and services produced within a country in a given
period of time.

THE MEASUREMENT OF
“GDP Is the Market Value …”
 GDP adds together many kinds of products into a single
measure of the value of economic activity.

THE MEASUREMENT OF
“… Of All Final Goods and Services …”
 Includes all items produced in the economy and sold legally in markets.
 GDP also includes the market value of the housing service (Rent).
 Some products are excluded: measuring them is difficult
 GDP includes only the value of final goods. The value of intermediate goods
is already included in the prices of the final goods.
 An important exception to this principle arises when an intermediate good is
produced and is added to a firm’s inventory of goods to be used or sold later.
 GDP includes both tangible goods (food, clothing, cars) and intangible
services (haircuts, housecleaning, dentist visits).

THE MEASUREMENT OF
“Produced Within a Country In a Given Period of Time.”
 GDP includes goods and services currently produced within
the geographic confines of a country.
 GDP measures the value of production that takes place within
a specific interval of time. Usually, the interval is a year or a
quarter. GDP measures the economy’s flow of income and
expenditure during that interval.

Quick
Quiz
Which contributes more to the GDP –

the production of a kilogram of hamburger
or the production of a kilogram of caviar?
Why?

THE COMPONENTS OF GDP
Y = C + I + G + NX
Y : GDP
C : Consumption
I : Investment
G : Government purchases
NX : Net exports
Active Learning
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 Toronto.
B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was
built in China.
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.
Active Learning
GDP and Its Components - Answers
A. Debbie spends $200 to buy her husband dinner at the finest

restaurant in Toronto.
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.

Active Learning
GDP and Its Components – Answers (cont’d)
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 worth of them.
Consumption rises by $470 million, inventory investment
rises by $30 million, and GDP rises by $500 million.
 Consumption: spending by households on goods and services,
except for purchases of new housing.
 Investment: spending on capital equipment, inventories, and
structures, including household purchases of new housing.
• Investment is the purchase of goods that will be used in the future
to produce more goods and services. By convention, the purchase
of a new house is the one form of household spending categorized
as investment rather than consumption.

 Government purchases: spending on goods and services
by local, territorial, provincial, and federal governments.
 Net exports: the value of a nation’s exports minus the
value of its imports; also called the trade balance.

case The Components of Canadian GDP
study

case The Components of Canadian GDP
study

Quick
Quiz
What are the four components of expenditure?

What does it mean when net exports have a
negative value?

REAL VERSUS NOMINAL GDP
 If total spending rises from one year to the next, one of
two things must be true:
1. The economy is producing a larger output of goods and services.
2. Goods and services are being sold at higher prices.
 When studying changes in the economy over time,
economists want to separate these two effects.

 Nominal GDP: the production of goods and services valued
at current prices.
 Real GDP: the production of goods and services valued at
constant prices.

TABLE 5.3
Real and Nominal GDP

 GDP deflator is a measure of the price level calculated
as the ratio of nominal GDP to real GDP times 100.

 Economists use the term inflation to describe a situation
in which the economy’s overall price level is rising.
 The inflation rate is the percentage change in some
measure of the price level from one period to the next.

case Real GDP over Recent History
study

Quick
Quiz
Define real and nominal GDP.

Which is a better measure of economic well-being?
Why?

GDP AND ECONOMIC WELL-BEING
 “GDP 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
wit nor our courage; neither our wisdom nor our learning; neither our
compassion nor our devotion to our country; it measures everything,
in short, except that which makes life worthwhile. And it tells us
everything about America except why we are proud that we are
Americans.”
Robert Kennedy (1968)

GDP AND ECONOMIC WELL-BEING
 Some things that contribute to a good life (well-being)
are left out of GDP.
 Leisure is left out.
 Activities that take place outside the markets are left out.
 The quality of the environment is excluded.
 The distribution of income.

case Measuring Economic Well-Being in Canada
study

case International Differences in GDP and
study the Quality of Life

IN THE
news Identifying the 1 Percent

Quick
Quiz
Why should policymakers care about GDP?

Classroom Activity
GDP and Economic Well-Being
1. If GDP is a good measure of economic well-being, why is
Switzerland’s gross domestic product so much lower than India’s
GDP or China’s GDP?
2. What measures would be better to compare the well-being of
different countries?
3. How do you expect these direct measures to correlate with per
capita GDP?

THE END

MEASURING THE COST
OF LIVING
Chapter 6

THE CONSUMER PRICE INDEX
 Consumer price index (CPI) is the overall measure of the
cost of the goods and services bought by a typical consumer.

HOW THE CONSUMER PRICE INDEX IS CALCULATED
 Every month, Statistics Canada computes and reports the CPI.
 It uses data on the prices of more than 600 different goods
and services.
 To see how these statistics are constructed, a simple
economy with two goods is used: hot dogs and hamburgers.

FIVE STEPS TO COMPUTING THE CPI AND THE
INFLATION RATE
1. Determine the basket. Which prices are most important
to the typical consumer.
2. Find the prices. Of each of the goods and services in
the basket for each point in time.
3. Compute the basket’s cost. At different times.

FIVE STEPS TO COMPUTING THE CPI AND THE INFLATION
RATE (CONT’D)
4. Choose a base year and compute the index.
5. Compute the inflation rate.

 Statistics Canada calculates several other price indexes.
 For each province and territory and for 19 cities across Canada.
 For some narrow categories of goods and services (such as food,
clothing, and shelter).
 “Core” inflation: a measure of the underlying trend in inflation.

TABLE 6.1
Calculating the Consumer Price Index and the Inflation Rate: An Example

What Is in the CPI’s Basket?
FYI

PROBLEMS IN MEASURING THE COST OF LIVING
 The CPI is not a perfect measure of the cost of living.
1. Commodity substitution bias
2. Introduction of new goods
3. Unmeasured quality change
 Taken together, these sources of bias cause the CPI to
overstate the cost of living by 0.5 percentage points per year
according to the Bank of Canada.
THE GDP DEFLATOR VERSUS THE CONSUMER PRICE INDEX
 Economists and policymakers monitor both the GDP deflator and the CPI to
gauge how quickly prices are rising.
 Two important differences can cause them to diverge:
• GDP deflator reflects the prices of all goods and services produced domestically,
whereas the CPI reflects the prices of all goods and services bought by consumers .
• The CPI compares the price of a fixed basket of goods to the price of the basket in
the base year, GDP deflator compares the price of currently produced goods to the
price of the same goods and services in the base year.

FIGURE 6.2
Two Measures of Inflation

Active Learning
Calculate the CPI
CPI basket: {10 kg beef, 20 kg chicken}

price of price of
beef chicken
The CPI basket cost $120 in 2017, the base
year. 2017 $4 $4
A. Compute the CPI in 2018.
2018 $5 $5
B. What was the CPI inflation rate
from 2018–2019? 2019 $9 $6

Active Learning
Calculate the CPI - Answers
A. Compute the CPI in 2018.

Cost of CPI basket in 2018 = ($5 × 10) + ($5 × 20) = $150
CPI in 2018 = 100 × ($150/$120) = 125

Active Learning
Calculate the CPI - Answers
B. What was the CPI inflation rate from 2018–2019?

Cost of CPI basket in 2019
= ($9 × 10) + ($6 × 20) = $210
CPI in 2019 = 100 × ($210/$120) = 175
CPI inflation rate 2019 / 2018 = (175 – 125)/125 = 40%

An Overview of Canada’s Consumer Price Index (CPI)
https://www.youtube.com/watch?v=qfKmJe3CK6E
The Consumer Price Index and Your Experience of Price

Change
https://www.youtube.com/watch?v=U0xDcqE-zNs

Quick
Quiz
Explain briefly what the consumer price index is

trying to measure and how it is constructed.

CORRECTING ECONOMIC VARIABLES
FOR THE EFFECTS OF INFLATION
 The purpose of measuring the overall level of prices in the
economy is to permit comparison between dollar figures
from different points in time.

DOLLAR FIGURES FROM DIFFERENT TIMES
 Was the 1957 price of 9.5 cents per litre high or low compared with the 2018
price of gas ($1.30 per litre)?
 To compare the 1957 price of gas with the 2018 price, we need to inflate the
price of 9.5 cents per litre to turn 1957 dollars into 2018 dollars.

The Bank of Canada’s Inflation
FYI Calculator
https://www.bankofcanada.ca/rates/relate
d/inflation-calculator/
A basket of goods and services that cost $100

in 1914 would cost how much in 1973?
In 1983? In 1993? In 2003? In 2018?

case
study
Mr. Index Goes to Hollywood
 MCQ: What is the most
popular movie of all time?
A. Avatar
What is the most popular movie of all time?
B. Titanic
C. Star Wars
D. Gone with the Wind

INDEXATION
 Indexation: the automatic correction of a dollar amount for
the effects of inflation by law or contract.
 COLA (cost-of-living allowance) automatically raises the
wage when the CPI raises.

REAL AND NOMINAL INTEREST RATES
 Interest rates involve comparing amounts of money at different
points in time.
 To fully understand interest rates, knowing how to correct for the
effects of inflation is important.
 Suppose you make a deposit of $1000 in a bank account that
pays interest at a rate of 10 percent per year.
 After one year, that bank account now contains $1100
(= principal of $1000 + interest of $100).
 Are you actually wealthier after one year?
REAL AND NOMINAL INTEREST RATES (CONT’D)
 Nominal interest rate: the interest rate that is usually
reported without a correction for the effects of inflation.
 Real interest rate: the interest rate that is corrected for
the effects of inflation.
 Real interest rate = Nominal interest rate - inflation rate

Quick
Quiz
Henry Ford paid his workers $5 a day in 1914.

The consumer price index was 5.95 in 1914 and
133 in 2018.
How much is the Ford daily paycheque worth in
2018 dollars?

case
study
Interest Rates in the Canadian Economy
What is the most popular movie of all time?

THE COSTS OF INFLATION
 Inflation is closely watched and widely discussed because
it is thought to be a serious economic problem.
 True?
 Why?

A FALL IN PURCHASING POWER? THE INFLATION FALLACY
 Inflation does not in itself reduce people’s real purchasing
power.
 If nominal incomes tend to keep pace with rising prices,
inflation is not a problem.
 There are, however, costs associated with inflation.

SHOELEATHER COSTS
 Shoeleather costs are the resources wasted when inflation
encourages people to reduce their money holdings.
MENU COSTS
 Menu costs are the costs of changing prices.

RELATIVE-PRICE VARIABILITY AND
THE MISALLOCATION OF RESOURCES
 Because prices change only once in a while, inflation causes
relative prices to vary more than they otherwise would.
 This issue is important because in market economies, we rely
on relative prices to allocate scarce resources.

INFLATION-INDUCED TAX DISTORTIONS
 Inflation tends to raise the tax burden on income earned
from savings.
 Inflation discourages saving is the tax treatment of capital gains.
 The income tax treats the nominal interest earned on savings as
income, even though part of the nominal interest rate merely
compensates for inflation.

TABLE 11.1
How Inflation Raises the Tax Burden on Saving

Active Learning
Tax Distortions
You deposit $1000 in the bank for one year.

CASE 1: Inflation = 0%, nom. interest rate = 10%
CASE 2: Inflation = 10%, nom. interest rate = 20%
A. In which case does the real value of your deposit grow the most?
Assume the tax rate is 25 percent.
B. In which case do you pay the most taxes?
C. Compute the after-tax nominal interest rate, then subtract off inflation to
get the after-tax real interest rate for both cases.

Active Learning
Answers
A. In which case does the real value of your deposit grow

the most?
In both cases, the real interest rate is 10 percent, so the real
value of the deposit grows 10 percent (before taxes).
B. In which case do you pay the most taxes?
CASE 1: interest income = $100, so you pay $25 in taxes.
CASE 2: interest income = $200, so you pay $50 in taxes.

Active Learning
Answers
C. Compute the after-tax nominal interest rate, then subtract

off inflation to get the after-tax real interest rate for
both cases.
CASE 1: Nominal = 0.75 × 10% = 7.5% real = 7.5% – 0%
= 7.5%
CASE 2: Nominal = 0.75 × 20% = 15% real = 15% – 10%
= 5.0%

Active Learning
Summary and Lessons
Inflation
Inflation ……
 Raises
Raises nominal
nominal interest
interest rates
rates (Fisher
(Fisher effect)
effect) but
but not
not real
real
interest
interest rates
rates
 Increases
Increases savers’
savers’tax
tax burdens
burdens
 Lowers
Lowers thethe after-tax
after-tax real
real interest
interest rate
rate

CONFUSION AND INCONVENIENCE
 Money is the ruler with which we measure economic transactions.
 The job of the BoC is a bit like the job of Measurement Canada.
 The BoC ensures the reliability of a commonly used unit of
measurement.
 When the Bank of Canada increases the money supply and creates
inflation, it erodes the real value of the unit of account.

A SPECIAL COST OF UNEXPECTED INFLATION:
ARBITRARY REDISTRIBUTIONS OF WEALTH
 Unexpected inflation redistributes wealth among the
population in a way that has nothing to do with either merit
or need.
 These redistributions occur because many loans in the
economy are specified in terms of the unit of account:
MONEY.
INFLATION IS BAD, BUT DEFLATION MAY BE WORSE
 Some of the costs of deflation mirror those of inflation.
 Menu costs
 Relative-price variability
 Redistribution of wealth toward creditors and away from
debtors
 A sign of broader macroeconomic difficulties

THE END

GDP_CPI and Inflation

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Adapted for the

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For an economy as a whole,

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What two things does gross domestic product

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Which contributes more to the GDP –

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In each of the following cases, determine how much GDP

A. Debbie spends $200 to buy her husband dinner at the finest

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

Copyright © 2020 by Nelson Education Ltd. 5-15

C. Jane spends $1200 on a computer to use in her editing business.

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What are the four components of expenditure?

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Define real and nominal GDP.

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Robert Kennedy (1968)

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Why should policymakers care about GDP?

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5. Compute the inflation rate.

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CPI basket: {10 kg beef, 20 kg chicken}

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A. Compute the CPI in 2018.

CPI in 2018 = 100 × ($150/$120) = 125

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B. What was the CPI inflation rate from 2018–2019?

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The Consumer Price Index and Your Experience of Price