Measuring a Nation’s Income and

the Cost of Living

Topic 3
 Real vs Nominal GDP

• Nominal GDP values the production of goods

and services at current prices.
• Real GDP values the production of goods and
services at constant prices (adjusted for
inflation).
 List of countries by
NOMINAL GDP per capita REAL GDP per capita
 Real vs Nominal GDP
• An accurate view of the economy requires
adjusting nominal to real GDP by using the
GDP deflator.
• GDP deflator is a measure of the price level
calculated as the ratio of nominal GDP to real
GDP times 100.
• It tells us the rise in nominal GDP that is
attributable to a rise in prices rather than a
rise in the quantities produced.
 Real vs Nominal GDP
• The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP
 Real vs Nominal GDP
Nominal GDPt=Q1t*P1t+Q2t*P2t+…+Qnt*Pnt

Real GDPt=Q1t*P1base+Q2t*P2base+…+Qnt*Pnbase,

where Qit denotes quantity of good i in year t,

Pit is the price of good i in year t
Pibase is the price of good i in base year.
 A numerical example

• Consider an economy producing only two

goods – apples and potatoes.
– Table 2a shows the quantities of the two
goods produced and their prices in the
years 2013, 2014 and 2015.
Table 2a Data example for calculating the real and
nominal GDP

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 Table 2b Nominal and Real GDP

Part of the rise is attributable to the increase in the quantities of apples and
potatoes and part to the increase in the prices of apples and potatoes. To
take out the effect of changes in prices we use real GDP

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 Table 2c Calculating the GDP deflator

For year 2013, nominal GDP is €200, and real GDP is €200, so
the GDP deflator is 100.

We now need the nominal GDP and the the real GDP for the
other two years to complete our calculations (see table 2a).

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 Real vs Nominal GDP

• Converting Nominal GDP to Real GDP

Nominal GDP20XX
Real GDP20XX   100
GDP deflator20XX
 Measuring the Cost of Living
• Inflation is the term used to describe a
situation in which the economy’s overall price
level is rising.
• The inflation rate is the percentage change in
the price level from the previous period.
 Measuring the Cost of Living
The consumer price index (CPI) is a measure of
the overall cost of the goods and services
bought by a typical consumer.
– The Office of National Statistics for UK and
Eurostat for Europe reports the CPI each
month.
– It is used to monitor changes in the cost of
living over time.
 Measuring the Cost of Living
The inflation rate is calculated as follows:

CPI in Year 2 - CPI in Year 1

Inflation Rate in Year 2 =  100
CPI in Year 1
 Five stages to calculating CPI

1. Fix the Basket - determine what prices

are most important to the typical consumer.
– The ONS identifies a market basket of goods
and services the typical consumer buys
(surveys)
2. Find the Prices of each of the goods and
services in the basket for each point in time.
 Five stages to calculating CPI
3. Compute the Basket’s Cost -using the data on
prices.
4. Choose a Base Year and Compute the Index:
– Designate one year as the base year.
– Compute the index by dividing the price of
the basket in one year by the price in the
base year and multiplying by 100.

5. Compute the inflation rate - the percentage

change in the price index from the preceding
period.
 Formula for CPI

Q1*P1t+Q2*P2t+…+Qn*Pnt
CPIt =
Q1*P1base+Q2*P2base+…+Qn*Pnbase

where Qi denotes quantity of good i the basket,

Pit is the price of good i in year t
Pibase is the price of good i in base year.
Table 1 Calculating the Consumer Price Index and the Inflation Rate: An
Example

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Table 1 Calculating the Consumer Price Index and the Inflation Rate: An
Example

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 Problems in Measuring the Cost of Living

Three key issues cause the CPI to overstate the

true cost of living:

• Substitution bias
• Introduction of new goods
• Unmeasured quality changes
 Problems in Measuring the Cost of Living

① Substitution Bias
• Consumers substitute toward goods that
have become relatively less expensive.
• The index overstates the increase in cost
of living by not considering consumer
substitution.
 Problems in Measuring the Cost of Living

② Introduction of New Goods

• New products result in greater variety,
which in turn makes each pound more
valuable.
• Consumers need less money to maintain
any given standard of living.
 Problems in Measuring the Cost of Living

③ Unmeasured Quality Changes

– If the quality of a good rises from one year
to the next, the value of a pound rises, even
if the price of the good stays the same.
– The ONS tries to adjust the price for
constant quality, but such differences are
hard to measure.
 Other prices indexes
• Producer price index - the cost of a basket of
goods and services bought by firms.

• GDP deflator - measures the level of prices of all

new, domestically produced, final goods and
services in an economy.

• Retail Price Index - measures the change in

the cost of a representative sample of retail
goods and services (published monthly by ONS).
 Other prices indexes
CPI vs RPI
• The CPI does not include any housing costs, such
as the effect of mortgage rates or council tax
while the RPI does.
• The RPI is used when calculating increases in
pensions, some State benefits and student loan
rates.
 Other prices indexes
CPI vs GDP Deflator

• The GDP deflator reflects the prices of all goods

and services produced domestically.

• The CPI reflects the prices of all goods and

services bought by consumers.
 Other prices indexes
CPI vs GDP Deflator
• The CPI compares the price of a fixed basket of
goods and services to the price of the basket in
the base year.

• The GDP deflator compares the price of currently

produced goods and services to the price of the
same goods and services in the base year.
 Other prices indexes
CPI vs GDP Deflator

• The CPI overstates inflation.

• The GDP deflator understates inflation.

• The CPI is also called Laspeyres index.

• The GDP deflator is also called Paasche index.
Figure 1 Two Measures of Inflation

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 Practice Question
• Which of the following would probably cause
the Consumer Prices Index (CPI) to rise more
than the GDP deflator in the UK? An increase
in the price of:
• A) BMWs produced in Germany and sold in the UK.
• B) Peugeots produced in the UK.
• C) Helicopters purchased by the Royal Navy.
• D) Domestically produced armoured vehicles sold
exclusively to India.
 Comparing Prices from Different Times

• Price indexes are used to correct for the

effects of inflation when comparing money
figures from different times.

• Did 1990 generation enjoy a higher or lower

standard of living than today’s generation?
 Comparing Prices from Different Times
Example
• The UK government is one of the oldest
parliaments.
• The members of parliament (MPs) were paid
nothing until 1911, when they first received a
salary of £400 a year.
Year MPs salary Price level
1911 £400 9.6
1931 £360 -
1937 £600 -
1977 £6,270 -
2012 £65,738 973.6
 Comparing Prices from Different Times

• We can convert members of parliament salary

in 1911 to a figure in 2012 pounds:
Price level in 2012
Salary2012  Salary1911 *
Price level in 1911

973.6
 £400 *
9.6

 £40,567
 Indexation
• When some money amount is automatically
corrected for inflation by law or contract, the
amount is said to be indexed for inflation.
 Indexation
• Macroeconomic variables adjusted using
indexation:
– Wages
– Capital gain
– Government bonds
 Real and Nominal Interest Rates
• Interest represents a payment in the future
for a transfer of money in the past.
• The nominal interest rate is the interest rate
usually reported and not corrected for
inflation.
• It is the interest rate that a bank pays.
• The real interest rate is the nominal interest
rate that is corrected for the effects of
inflation.
 Real and Nominal Interest Rates
Example
– You borrowed £1,000 for one year.
– Nominal interest rate was 15%.
– During the year inflation was 10%.

Real interest rate = Nominal interest rate –

Inflation
= 15% - 10% = 5%
 Summary
① The consumer price index shows the cost
of a basket of goods and services relative
to the cost of the same basket in the base
year.
② The index is used to measure the overall
level of prices in the economy.
③ The percentage change in the CPI
measures the inflation rate.
 Summary
④ The consumer price index is an imperfect
measure of the cost of living for the
following three reasons:
– substitution bias,
– the introduction of new goods,
– and unmeasured changes in quality.
 Summary
⑤ The GDP deflator differs from the CPI
because it includes goods and services
produced rather than goods and services
consumed.
⑥ In addition, the CPI uses a fixed basket of
goods, while the GDP deflator
automatically changes the group of goods
and services over time as the
composition of GDP changes.
 Summary
⑦ Money figures from different points in
time do not represent a valid comparison
of purchasing power.
⑧ Various laws and private contracts use
price indexes to correct for the effects of
inflation.
⑨ The real interest rate equals the nominal
interest rate minus the rate of inflation.