5 Steps to a 5 AP Macroeconomics 2019

Macroeconomic Measures of Performance ❮ 83

Price index current year = 100 ë (Spending current year)/(Spending base year)

2016 price index = 100 × (531)/(486) = 109.26

Inflation

In the above example, the price index increased from 100 in the base year to 109.26 in

2016. In other words, the average price level increased by 9.26 percent.
      On a much larger scale, the official CPI is constructed and used to measure the increase
      in the average price level of consumer goods. The annual rate of inflation on goods con-
      sumed by the typical consumer is the percentage change in the CPI from one year to the
      next.

So What Is the Difference Between the CPI and the GDP Deflator?

This concept can be confusing. The difference between these two price indices lies in the

content of the market basket of goods. The CPI is based upon a market basket of goods

bought by consumers, even those goods that are produced abroad. The GDP deflator

includes all items that make up domestic production. Because GDP includes more than

just consumer goods, the index is a broader measure of inflation, while the CPI is a meas-

ure of inflation of only consumer goods. Since consumer spending is so important to the

economy, making up about 70 percent of U.S. GDP each year, the CPI is a very important

indicator of what is happening in the broader economy.

• Consumer inflation rate = 100 × (CPI new – CPI old)/CPI old

Nominal and Real Income

As a consumer, I am also a worker and an income earner. Rising consumer prices hurt my

ability to purchase the items that make me happy. In other words, rising prices can cause a

decrease in my purchasing power. Ideally, I would like to see my income rise at a faster rate

than the price of consumer goods. One way to see if this is happening is to deflate nominal

income by the CPI to calculate my real income. Real income is calculated in the same way

that real GDP is calculated.

• Real income this year = (Nominal income this year)/CPI (in hundredths)

Example:

In 2014 Kelsey’s nominal income was $40,000, and it increases to $41,000 in

2015. Curious about her purchasing power, she looks up the CPI in 2014 and
      finds that at the end of that year it was 234.8; at the end of 2015 it was 236.5.
      This is compared to the base year value of 100 in 1984.
      Real income 2015 = $40,000/2.348 = $17,036
      Real income 2016 = $41,000/2.365 = $17,336
      What we have done here is converted Kelsey’s nominal incomes in 2014 and 2015, which
      were each a function of prices on those two years, into constant 1984 dollars. In other
      words, we have adjusted (or deflated) incomes measured in two different years so they are
      measured with the prices that existed in one year. After accounting for inflation, Kelsey’s
      real income increased by $300. Her nominal income increased at a rate slightly faster than
      the rate of inflation, and so her purchasing power has slightly increased.

TIP

“Know these
things for
multiple-choice
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—Lucas,
AP Student