D.  Inflation, Real GDP, and Business Cycles

1.  Inflation

• Sustained increase in the average price level

a.  Real vs. nominal GDP

.

.

.

.

.

.

.

.

.

.

b.  Inflation measures

(1)  GDP Price Deflator / Index (Implicit Price Index)

.

.

.

(2)  Consumer Price Index

• Measure of the weighted-average change in prices for a market basket of goods and services purchased by a typical urban family of four 

.

• Calculated by the Bureau of Labor Statistics

- 96,000 goods and services

- 23,000 stores in 87 cities

- Market basket updated every two years

.

• Compares prices in a given year to prices in a base year

.

.

.

.

.

.

.

.

.

.

.

• Shortcomings of the CPI

- Nonrepresentative market basket

.

- Inaccurate treatment of quality changes

.

- New products not counted

.

 - Overstates inflation because substitution effect not considered

. 

(3)  Producer Price Index

• Measures price changes at the wholesale level

.

• Measures prices firms pay for:

- Crude materials for further processing

- Intermediate materials, supplies, and components

- Finished goods

.

• Calculated by the Bureau of Labor Statistics

- 3,500 items measured

.

(4)  Employment Cost Index

• Measures weighted-average cost of an hour of labor

.

(5)  Personal Consumption Expenditure Price Index

• Measures changes in domestic consumer goods and services purchased by household sector

.

• Doesn't use fixed market basket

- Same approach as GDP deflator, uses only consumption category of GDP

- Chain-type index - base year only one year behind current year, constantly changes

- Deals with new products and quality changes

- Broader measure - more goods and services included than CPI

- Past values can be recalibrated as more data becomes available

.

• Federal Reserve now uses PCE as target instead of CPI

.

(6)  Core inflation

• Excludes volatile commodities (food and energy)

.

c.  Compound annual inflation rate

.

.

.

.

.

.

d.  Real values

.

.

.

.

2.  Business cycles

• Recurring, irregular, and unsystematic movements in real economic activity around a long-term trend

.

.

.

.

.

.

.

.

.

.

• Caused by supply side or demand side factors

.

a.  Economic variables and the business cycle

• Procyclical - move in same direction as business cycle

• Countercyclical - move in the opposite direction as business cycle

• Acyclical - do not change with the business cycle

• p. 133

.

b.  Economic indicators

• Leading indicators - move ahead of the economy

• Coincident indicators - move with the economy

• Lagging indicators - move after the economy moves

• Calculated by the Conference Board