CPI & GDP Deflator

CPI VS GDP DEFLATOR
The GDP Deflator measures the prices of all goods produced, whereas the CPI measures prices of only the goods and services bought by consumers.

GDP = Nomial GDP X 100
Deflator Real GDP

• An increase in the price of goods produced by government will show up in the GDP Deflator but not the CPI
• The GDP Deflator includes only those goods and services produced domestically. Since imported goods are not part of GDP they do not show up on the GDP deflator.

PROBLEMS OF THE CPI
Substitution biased
• As prices for the fixed market basket, consumers buy less of these products and more substitutes that may not be part of the market basket.
- Result: CPI may be higher than what consumers are really paying.
New Products
• The CPI market basket may not include the newest consumer products.
-Result: CPI measures prices but not the increase in choices
Product Quality
• CPI ignores both improvements and decline in product quality
- RESULT: CPI may suggest that prices stay the same though economic well
being has improved significantly.

THREE CAUSES OF INFLATION
13. If everyone suddenly had a million dollars what would happen?
14. What two things cause prices to increase? Supply and demand

3 causes of inflation
15. The government prints too much money (The Quantity Theory)
• Governments that keep printing money to pay debts endue with hyperinflation
• There are more "rich" people but the same amount of products
• Result: banks refuse to lend and GDP falls
If the real GDP in a year is $400 billion but the amount of money in the economy is only $100 billion, how are we paying for things?
- The velocity of money is the average times a dollar is spent and re-spent in a
year.
• Quantity of money equation
(MONEY SUPPLY)*(VELOCITY) = (PRICE LEVEL)*(QUANTITY OF OUTPUT)
- Notice that P*Y is GDP

Why does printing money lead to inflation?
• Assume the velocity is relatively constant because people's spending habits are not quick to change
• Also assume that output (Y) is not affected by the amount of money because it is based on production, not the value of the stuff produced.
If the government increases the amount of money (M) what will happen to prices (P)
• EX. Assume money supply is $5 and it is being used to by 10 products with a price of $2 each.
• How much is the velocity of money?
• If the velocity and output stay the same, what will happen if the amount of money is increased to $10
- Notice doubling money doubles prices

CAUSES OF INFLATION
2. Demand - pull inflation
• Demand increases but supply stays the same. What is the result?
• A shortage driving prices up
• An over heated economy with excessive spending but the same amount of goods.
3. Cost - Push inflation
• Higher production costs increase prices
• A negative supply shock increases the costs of production and forces producers to
increase prices
- Hurricane Katrina destroyed oil refineries and caused gas prices to go up.
Companies therefore charged more for any good or service requiring gas in the
production.

WAGE PRICE SPIRAL
A Perpetual Process:
16. Workers demand raises
17. Owners increase prices to pay for raises
18. Higher prices cause workers to demand higher raises
19. Owners increase prices to pay for higher raises...
20. ....
21. ....
22. ....
23. ....
24. Stupid unions.

BALANCE OF TRADE VS BALANCE OF PAYMENTS
• Net exports = Exports - imports
• Trade surplus = Exporting more than is imported.
• Trade deficit = Exporting less than is imported.

BALANCE OF PAYMENTS (BOP)
• Balance of trade includes only goods and services but balance of payments considers all international transactions
• Balance of payments is a broader measure of international trade.

Details
• The BOP summary is within a given year.
• Prepared in the domestic country's currency
• The balance of payments is made up of two accounts. The CURRENT ACCOUNT and the CAPITAL ACCOUNT.

Current account
• Made up of three parts
25. Trade goods and services
• Net exports- difference between a nation's exports of goods and services and
its imports of goods and services.
2. Investment income - Income from the factors of productions including payments
made to foreign investors
• Money earned by a Japanese car company in the US
3. Net Transfers - Money flows from the private or public sectors
• Donations, aids, and grants

CAPITAL ACCOUNT
The capital account measures the purchase and sales of financial assets abroad.
Purchases of things that stay in the foreign country
Examples:
- US company buys hotel in Russia
- A korean company sells a factory in Ohio
- Australian company buys the Temple Mall.