Unit 4 Inflation and Unemployment.pdf - Price Indices and...

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• Price Indices and Real versus Nominal ValuesReal versus Nominal ValuesPrices in an economy do not stay the same. Over time the price level changes (i.e., there is inflationor deflation). A change in the price level changes the value of economic measures denominated indollars. Values that increase or decrease with the price level are called nominal values. Real values areadjusted for price changes. That is, they are calculated as though prices did not change from the baseyear. For example, gross domestic product (GDP) is used to measure fluctuations in output. However,since GDP is the dollar value of goods and services produced in the econom}5 it increases whenprices increase. This means that nominal GDP increases with inflation and decreases with deflation.But when GDP is used as a measure of short-run economic growth, we are interested in measuringincreases or decreases in output, not prices. That is why real GDP is a better measure of economicperformance--real GDP takes out the effects of price changes and allows us to isolate changes inoutput. Price indices are used to adjust for price changes. They are used to convert nominal values intoreal values.Calculating Price IndicesThe first step in converting nominal values to real values is to create a price indexÿ A price indexcompares the total cost of a fixed market basket of goods in different years. The total cost of themarket basket is found by multiplying the price of each item in the basket by the quantity of the itemin the basket and then summing the results for all items. The cost of the market basket in the currentyear is then divided by the cost of the basic market basket in the base year as shown below:Price index - current-year cost x 100.base-year costMultiplying by 100 allows comparison of the index in each year to the base-year index value of 100.The base yeaz always has an index number of 100 since the current-year cost and the base-year cost of themarket basket are the same in the base year.The Consumer Price Index (CPI) is a commonly used price index that measures the price of a marketbasket of consumer goods. The following example shows how the CPI can be used to measure inflation.Advanced Placement Economics Macroeconomics: Student Resource Manual © Council for Economic Education, New York, N.Y. 6 5

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