1
2
3
Unit 2 - Economic Indicators and the Business Cycle
Enduring Understanding
• An economy’s performance can be measured by different indicators such as gross
domestic product (GDP), the inflation rate, and the unemployment rate
Skill 1.C:
• Identify an economic concept, principle, or model using quantitative data or
calculations
4
Topic 2.4: Price Indices and Inflation
Learning Objectives:
• Define the consumer price index (CPI), inflation, deflation, disinflation, the inflation rate, and real
variables
• Explain how price indices can be used to calculate the inflation rate and to compare nominal
variables over time periods
• Calculate the CPI, the inflation rate, and changes in real variables
• Define the shortcomings of the CPI as a true measure of inflation
Topic 2.5: Costs of Inflation
Learning Objective:
• Explain the costs that unexpected inflation (deflation) imposes on individuals and the economy
Topic 2.6: Real v. Nominal GDP
Learning Objectives:
• Define nominal GDP and real GDP
• Calculate real GDP and the GDP deflator
Topic 2.7: Business Cycles
Learning Objectives:
• Define and explain (using graphs and data as appropriate) turning points and phases of the business
cycle
5
LESSON OVERVIEW
DIVIDER SLIDE
TEACHER NOTES & REQUIREMENTS
DELETE THIS PLACEHOLDER SLIDE FROM
YOUR FINAL PRESENTATION
• This slide will be pre-made for you, by the College Board design team.
The PPC
2017 Q. 3 (sort of)
A country is at full employment and produces two types of goods: consumer goods and capital
goods. The natural rate of unemployment is 5%.
a) Draw a correctly labeled graph of the production possibilities curve, with consumer
goods on the horizontal axis and capital goods on the vertical axis.
a) Indicate a point on your graph, labeled X, that represents full employment and a
possible combination in which both goods are being produced.
b) Indicate a point on your graph, labeled Y, that represents a possible combination in
which both goods are being produced, corresponding with an unemployment rate of
8%.
c) Indicate a point on your graph, labeled Z, that represents a possible combination in
which both goods are being produced, corresponding with an unemployment rate of
3%.
7
The PPC
2017 Q. 3
A country is at full employment and produces two types of goods: consumer goods and capital goods. The natural rate of
unemployment is 5%.
a) Draw a correctly labeled graph of the production possibilities curve, with consumer goods on the horizontal axis
and capital goods on the vertical axis.
a) Indicate a point on your graph, labeled X, that represents full employment and a possible combination in
which both goods are being produced.
b) Indicate a point on your graph, labeled Y, that represents a possible combination in which both goods are
being produced, corresponding with an unemployment rate of 8%.
c) Indicate a point on your graph, labeled Z, that represents a possible combination in which both goods are
being produced, corresponding with an unemployment rate of 3%.
Capital
Goods
Z
Consumer Goods
What You Need to Know
2.4: Price Indices and Inflation
The Consumer Price Index (CPI) measures the change in income a consumer would need in order to
maintain the same standard of living over time under a new set of prices as under the original set of prices.
What is the Consumer Price Index?
• The CPI is a measure of the average change over time in the prices paid by urban consumers
for a FIXED “basket” of consumer goods and services.
What is the CPI used for?
• It is a way to compute the purchasing power of an average American family living in an
urban area
• Inflation: an overall increase in prices; inflation erodes the purchasing power of a
given income
• As prices rise relative to income, the purchasing power of a given income falls
• Deflation: an overall decrease in prices; deflation strengthens the purchasing power of
a given income
• As prices fall relative to income, the purchasing power of a given income
increases.
10
2.4: Price Indices and Inflation
The CPI measures the cost of a fixed basket of goods and services in a given year relative to the base year.
How does the CPI work?
• Consumers report information to the on what they
buy to the U.S. Bureau of Labor Statistics (BLS)
• The cost of those items is computed into a “market
basket”
• (P1 * Q1) + (P2 * Q2) + (P3 * Q3), etc.
• The value of the market basket in a given year is
compared to the value of the market basket in a
base year
• The CPI for the current year:
x 100
Source: BLS 2015
• The CPI for the base year is always 100
11
Three steps to calculating the inflation rate using the CPI
1. Compute the value of the market basket for the base year and the current year
• Market basket in base year = (PBY1 * QBY1) + (PBY2 * QBY2) + (PBY3 * QBY3)
• Market basket in current year = (PCY1 * QBY1) + (PCY2 * QBY2) + (PCY3 * QBY3)
2. Divide the current year market basket by the base year market basket to get the CPI
• CPI =
• The base year market basket will always be 100
3. Calculate the rate of change between the base year CPI and the current year CPI
Rate of change =
12
2.4: Price Indices and Inflation
The CPI measures the cost of a fixed basket of goods and services in a given year relative to the base year.
FIXED Basket of Goods and Services (2019 is base year)
2019 2019 2019 Market 2020 2020 2020 Market
Price Quantity Basket Price Quantity Basket
Good 1 $2.00 20 $40.00 $2.10 18 $42.00
Good 2 $4.00 10 $40.00 $4.60 13 $46.00
Good 3 $3.00 40 $120.00 $3.30 41 $132.00
Market Basket Base Year Base Year $200 Current Year Base Year $220.00
Price X Quantity Price Quantity
2019 CPI = x 100 2020 CPI = x 100
2019 CPI = x 100 = 100 2020 CPI = x 100 = 110
2019 CPI = 100 2020 CPI = 110
13
2.4: Price Indices and Inflation
The inflation rate is determined by calculating the percentage change in a price index, such as CPI or the
GDP deflator.
How to calculate the inflation rate using the CPI
Use the rate of change formula: x 100
• 2019 CPI = 100
• 2020 CPI = 110
What was the inflation rate from 2019 to 2020?
• 2019 is old
• 2020 is new
Inflation rate from 2019 to 2020 = x 100
Inflation rate from 2019 to 2020 = x 100 = x 100 = 10%
14
2.4: Price Indices and Inflation
Real variables, such as real wages, are the nominal variables deflated by the price level.
Nominal vs. real
• Google definition of nominal: “Existing in name only”
• Nominal – NOT adjusted for inflation, or changes in the price level
• Real – adjusted for inflation, or changes in the price level
• Nominal wages – how much you make
• Real wages – the purchasing power of a nominal wage
Example:
• Nominal wage rises from $20,000 per year to $30,000 per year
• Nominal wage increases by 50%
• CPI rises from 100 to 175
• Price level rises by 75%
• What happened to real wage?
• It fell because overall prices are rising faster than wages
17
2.4: Price Indices and Inflation
The CPI as a measure of inflation has some shortcomings, such as substitution bias, causing it to overstate
the true inflation rate.
How can the CPI overstate the true inflation rate?
• Substitution bias
• FIXED basket - market basket does not change to reflect consumer reaction to changes
in relative prices
• Consumers substitute toward goods that have become relatively less expensive
• Introduction of new goods
• The market basket does not reflect the change in purchasing power brought on by the
introduction of new products
• New products result in greater variety, which in turn makes each dollar more
valuable (i.e., greater purchasing power)
• Consumers need fewer dollars to maintain any given standard of living
• Music streaming services vs. individual downloads of MP3 files
• Unmeasured quality changes
• If the quality of the good rises (falls) from one year to the next, the value of a dollar
rises (falls), even if the price of the good stays the same
18
2.4: Price Indices and Inflation
The CPI as a measure of inflation has some shortcomings, such as substitution bias, causing it to overstate
the true inflation rate.
Why does it matter if the CPI overstates the true inflation rate?
• Many government programs use the CPI to adjust for changes in the overall level of prices
• These are called cost of living adjustments (COLAs)
• If the CPI overstates the inflation rate, then cost of living adjustments will be higher than
they need to be
19
2.5: Costs of Inflation
Unexpected inflation arbitrarily redistributes wealth from one group of individuals to another group, such
as lenders to borrowers.
Who wins and who loses when inflation is HIGHER than expected?
• People build expectations of inflation into their decision making
• When inflation is HIGHER than expected, the purchasing power of a given amount of
money to be received in the future is LOWER than expected
• Beneficiaries (winners) of unanticipated inflation:
• Anyone PAYING money at a fixed amount
• Borrowers benefit
• Losers from unanticipated inflation:
• Anyone RECEIVING money at a fixed amount
• Lenders lose
• People on fixed incomes
• Social security recipients
• Workers subject to multi-year wage agreements
20
2.6: Real v. Nominal GDP
Learning objectives: Define nominal GDP and real GDP
Calculate real GDP and the GDP deflator
• Nominal GDP is a measure of how much is spent on output.
• Aggregate output times current prices
• (PCY1 * QCY1) + (PCY2 * QCY2) + (PCY3 * QCY3)
• Real GDP is a measure of how much is produced.
• Aggregate output times constant prices
• (PBY1 * QCY1) + (PBY2 * QCY2) + (PBY3 * QCY3)
• GDP Deflator =
• GDP Deflator =
• Real GDP = Nominal GDP = Real GDP x GDP Deflator
21
Comparing the CPI and the GDP Deflator
The CPI and the GDP Deflator are both indexes used to measure inflation
CPI GDP Deflator
• The CPI is used to determine how • The GDP Deflator is used to determine
purchasing power has changed over how output has changed over time
time • Based on the goods and services
• Based on changing prices of a fixed produced in a given period (P, Q Δ)
market basket (PΔ, Q)¯ ¯
• Holds prices constant and evaluates
• Holds quantity constant and evaluates changing output
changing prices • Reflects all prices of all goods and
• Reflects the prices of goods and services produced domestically
services bought by consumers • Meaning…C, I, G, X
• Meaning…C (includes imports)
22
23
Putting it all together
Unit 2 – Economic Indicators and the Business Cycle
An economy’s performance can be measured by different indicators such as gross domestic
product (GDP), the inflation rate, and the unemployment rate.
What you need to know:
- How is each calculated?
- What do they (and don’t they) tell us about the overall health of an economy?
- What are the weaknesses of each?
- How to interpret each in terms of the business cycle.
24
2.7: The Business Cycle
Business cycles are fluctuations in aggregate output and employment because of changes in
aggregate supply and/or aggregate demand.
• The phases of the
business cycle are
recession and
expansion.
• The turning points of a
business cycle are
peak and trough.
This Photo by Unknown Author is licensed under CC BY-SA 25
2.7: The business cycle
The difference between actual output and potential output is the output gap.
Potential output is also called full-employment output. It is the level of GDP where
unemployment (UR) is equal to the natural rate of unemployment (NRU).
Current output equals
potential output
Real GDP
Current output is greater
than potential output
(inflationary gap; UR < 3%
NRU)
X Current output is less
Y than potential output
(recessionary gap; UR
> NRU)
Time
26
29
2008 Form B. Q. 3
3. Gala Land produces three final goods: bread, water, and fruit.
The table above shows this year’s output and price for each
good.
a) Calculate this year’s nominal gross domestic product
(GDP).
b) Assume that in Gala Land the GDP deflator (GDP price
index) is 100 in the base year and 150 this year.
Calculate each of the following.
i. The inflation rate, expressed as a percentage,
between the base year and this year
ii. This year’s real GDP
c) Since the base year, workers have received a 20 percent
increase in their nominal wages. If workers face the same
inflation that you calculated in part (b)(i), what has
happened to their real wages? Explain.
d) If the GDP deflator in Gala Land increases unexpectedly,
would a borrower with a fixed-interest-rate loan be better
off or worse off? Explain.
30
31
Topics 2.4-2.7
Price Indices and Inflation, Costs of Inflation, Real v. Nominal
GDP, & The Business Cycle
• Define the CPI, inflation, deflation, disinflation, the inflation rate, and real variables.
• Explain how price indices can be used to calculate the inflation rate and to compare nominal
variables over time periods.
• Calculate the CPI, the inflation rate, and changes in real variables.
• Define the shortcomings of the CPI as a true measure of inflation
• Explain the costs that unexpected inflation (deflation) imposes on individuals and the
economy.
• Define nominal GDP and real GDP
• Calculate real GDP and the GDP deflator
• Define and explain (using graphs and data as appropriate) turning points and phases of the
business cycle.
32
Device and Internet Access
We know that not all students have access to the internet or a
device. We’re working on solutions to help students get what they
need to show their best work. If you need mobile tools or
connectivity or know someone who does, you can reach us
directly to let us know.
cb.org/tech
34
