Macro.Week3.2008 - II-3/1 Review 3 Does G.D.P measure how...

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II-3/1 Review: 3. Does G.D.P. measure how well off we are? “sort of” - it measures our access to goods and services that are sold through the market BUT - it does not account for harm done during production - it does not account for depletion of scarce resources - it does not include illegal activity - it does not include household production - it does not include volunteer work 4. How to correct for prices? Suppose we know that I spent $6000 in 1973, and $50,000 last year. When was I better off? And by how much? The problem is that $6000 represents the value of the bundle of goods and services that I bought in 1973, at 1973 prices, i.e. P 1973 t B 1973 and the $50,000 represents the value of the bundle of goods and services that I bought in 2006, at 2006 prices, i.e. P 2006 t B 2006 What we really want to do is value the two bundles at the same prices and see which one is more valuable
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II - 3/2 Three ways we can do that: 1. Value both bundles in 1973 prices So: compare P 1973 t B 1973 and P 1973 t B 2006 the 1973 bundle is already valued that way, $6000 or P 1973 t B 1973 the 2006 bundle is P 2006 t B 2006 and we want to convert it into P 1973 t B 2006 We could do this using BAD LINEAR ALGEBRA by multiplying by P 1973 /P 2006 so ( P 2006 t B 2006 )( P 1973 /P 2006 ) = P 1973 t B 2006 It looks like we can cancel P 2006 and “sort of” get P 1973 t B 2006 which would be the 2006 bundle valued at 1973 prices. Unfortunately, linear algebra does NOT (!!!!!) work this way. We can’t take the ratio of two vectors P 1973 /P 2006 and vectors don’t cancel this way. BUT if think about P 1973 /P 2006 as the ratio of the price indexes, it actually sort of works So what we do is compare P 1973 t B 1973 with P 2006 t B 2006 X ratio of (price indexes in 1973 and 2006)
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II – 3/3 The second way to make the comparison is 2. Value both bundles in 2006 prices the 2006 bundle is already valued that way, $50,000 or P 2006 t B 2006 the 1973 bundle can be converted by multiplying by Price index in 2006/Price index in 1973 so $6000( P 2006 /P 1973 ) or ( P 1973 t B 1973 )( P 2006 /P 1973 ) THIS IS BAD LINEAR ALGEBRA BUT IT HELPS US REMEMBER 3. Value both bundles in some other year’s prices - say 1988 prices the 1973 bundle can be converted by multiplying by Price index in 1988/Price index in 1973 so $6000( P 1988 /P 1973 ) or ( P 1973 t B 1973 )( P 1988 /P 1973 ) the 2006 bundle can be converted by multiplying by Price index in 1988/Price index in 2006 so $50,000( P 1988 /P 2006 ) or ( P 2006 t B 2006 )( P 1988 /P 2006 )
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II-3/4 Now: Correcting for prices: GDP = $200 in year 1 = $240 in year 2 We say that “nominal” GDP, or “current dollar” GDP has risen by 20% Now suppose price index (GDP deflator) = 125 in year 1 = 140 in year 2 (100 in year 0) We want some measure of GDP in unchanged prices:
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