EC 205 Macroeconomics I

Lecture 3

EC 205 Fall 2013

Lecture 3

Announcement

Regular Office Hours on W56

(Wednesday,13:00-14:50, NB 212)

No longer on T3Th3

EC 205 Fall 2013

Lecture 3

Understanding the CPI

Example with 3 goods

For good i = 1, 2, 3


Qi = the amount of good i in the CPIs basket


(note that it does not depend on time)


Pit = the price of good i in month t


Et = the cost of the CPI basket in month t


Eb = the cost of the basket in the base period

EC 205 Fall 2013

Lecture 3

Understanding the CPI

CPI in month t =

Et
Eb

P1t Q1 + P2t Q 2 + P3t Q3

Eb

Q
Q
Q
= 1 P1t + 2 P2t + 3 P3t
Eb
Eb
Eb
The CPI is a weighted sum of prices.

The weight on each price reflects 
that goods relative importance in the CPIs basket.

Note that the weights remain fixed over time.

EC 205 Fall 2013

Lecture 3

Two measures of inflation in the U.S.

15%

Percentage change 

from 12 months earlier

CPI

10%

5%

GDP deflator

0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

EC 205 Fall 2013

Lecture 3

Two measures of inflation in Turkey

140%
120%
100%
80%
60%
40%

CPI I nfl ati on

GDP Deflator I nflation

20%
0%
1960

1965

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1970

1975

1980

1985

Lecture 3

1990

1995

2000

2005

2010
6

Why the CPI may overstate inflation

Substitution bias: 
The CPI uses fixed weights, so it cannot reflect
consumers ability to substitute toward goods whose
relative prices have fallen.

Introduction of new goods: 
The introduction of new goods makes consumers
better off and, in effect, increases the real value of the
dollar. But it does not reduce the CPI, because the
CPI uses fixed weights.

Unmeasured changes in quality: 
Quality improvements increase the value of the dollar,
but are often not fully measured.

EC 205 Fall 2013

Lecture 3

The size of the CPIs bias

In 1995, a Senate-appointed panel of experts
estimated that the CPI overstates inflation by about
1.1% per year.

So the BLS made adjustments to reduce the bias.

Now, the CPIs bias is probably under 1% per year. 

EC 205 Fall 2013

Lecture 3

CPI vs. GDP Deflator

Prices of capital goods:

included in GDP deflator (if produced domestically)

excluded from CPI

Prices of imported consumer goods:

included in CPI

excluded from GDP deflator

The basket of goods:

CPI: fixed

GDP deflator: changes every year

EC 205 Fall 2013

Lecture 3

Labor-related Categories of the

Population

employed 
working at a paid job

unemployed 

not employed but looking for a job

labor force 

the amount of labor available for producing goods

and services; all employed plus unemployed persons

not in the labor force 

not employed, not looking for work

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Two important labor force concepts

unemployment rate 
percentage of the labor force that is unemployed

labor force participation rate 

the fraction of the adult population 
that participates in the labor force

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Example: 

data: E = 139.1, U = 14.8, POP = 238.5

labor force

L = E +U = 139.1 + 14.8 = 153.9

not in labor force

NILF = POP L = 238.5 153.9 = 84.6

unemployment rate

U/L x 100% = (14.8/153.9) x 100% = 9.6%

labor force participation rate

L/POP x 100% = (153.9/238.5) x 100% = 64.5%

Measuring the Unemployment Rate

Turkey (2011)

Population

73,700,000

Population (16+)

53,800,000

Labor Force Participation (F)

28.1%

Labor Force Participation (M)

71.4%

Labor Force Participation (T)

49.5%

Unemployment Rate (F)

Unemployment Rate (M)

11.3%

Unemployment Rate (T)

9.8%

9.2%

Nonagriculture unemployment rate: ~12.5%

U(Urban)>U(Rural) (~11% vs ~5.5)

Youth Unemployment:~18%

48% of the economy is informal in Turkey (estimate)

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How do we actually measure it?

Until recently, mostly people who were registered at unemployment
offices were counted as unemployed

Today most countries rely on large surveys of households

For example, the Current Population Survey (CPS) in the US

60000 households are interviewed every month

If an individual has a job during the month of interview employed

If an individual is looking for a job during the month of interview

unemployed

If not employed and not looking for a job not in the labor force

Discouraged workers: This method tends to underreport the rate of

unemployment

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Two arithmetic tricks for 

working with percentage changes

1. For any variables X and Y,


percentage change in (X Y )


percentage change in X


+ percentage change in Y

d(XY)=Y dX + X dY d(XY)/XY = dX/X + dY/Y

EX:

If your hourly wage rises 5% 
and you work 7% more hours, 
then your wage income rises 
approximately 12%.

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Two arithmetic tricks for 

working with percentage changes

2. percentage change in (X/Y )

percentage change in X

percentage change in Y

d(X/Y)=(Y dX - X dY)/Y2

d(X/Y)/(X/Y) = (Y dX - X dY)/Y2 (X/Y)= dX/X - dY/Y

EX:
GDP deflator = 100 NGDP/RGDP.


If NGDP rises 9% and RGDP rises 4%, 
then the inflation rate is approximately 5%.

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Example: 

Calculate percentage changes in 

labor statistics

Suppose

population increases by 1%

labor force increases by 3%

number of unemployed people increases by 2%

Calculate the percentage changes in the labor force
participation and unemployment rates.

Example: 

Answers

LFPR = L/POP

L increases 3%, POP increases 1%, so
LFPR increases 3% 1% = 2%

U rate = U/LF

U increases 2%, LF increases 3%, so
U-rate increases 2% 3% = 1%

Note: the changes in LFPR and U-rate are shown as percent of
their initial values, not in percentage points! E.g., if initial value
of LFPR is 60.0%, a 2% increase would bring it to 61.2%,
because 2% of 60 equals 1.2.

Chapter Summary

Gross Domestic Product (GDP) measures both total
income and total expenditure on the economys
output of goods & services.

Nominal GDP values output at current prices; 

real GDP values output at constant prices. Changes
in output affect both measures, 
but changes in prices only affect nominal GDP.

GDP is the sum of consumption, investment,

government purchases, and net exports.

Chapter Summary

The overall level of prices can be measured 
by either:

the Consumer Price Index (CPI), 
the price of a fixed basket of goods purchased by
the typical consumer, or

the GDP deflator, 
the ratio of nominal to real GDP

The unemployment rate is the fraction of the labor

force that is not employed.