Economics: Principles and Policy

William J. Baumol, Alan S. Blinder, John L. Solow

14th edition

Powerpoint Slides prepared by:

Philip Heap, James Madison University

Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © 2000 Cengage. All Rights
Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or
in part.
 Part 2

The Macroeconomy: Aggregate Supply and

Demand

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 Chapter 6

The Goals of Macroeconomic Policy

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 Introduction

Two tasks of macroeconomic policy:

1. Growth policy
• Intended to make the economy grow faster in the long-run

2. Stabilization policy
• Manage aggregate demand to:
• Avoid high unemployment
• Avoid high inflation

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 The Goal of Economic Growth

• Economic growth over the very very long run

• For much of our existence, living standards barely changed
• Took off around the start of the Industrial Revolution

• Annual growth rates are typically small (1-2%), but accumulate over time:
• From 1870-1979:
• US growth: 2.3% per year
▶ 100 x (1 + 0.023)
109 = 1,192.46%

• UK growth: 1.8% per year

▶ 100 x (1 + 0.018)
109 = 699.05%

• Japan growth: 3% per year

▶ 100 x (1 + 0.03)
109 = 2,507.06%

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 The Goal of Economic Growth

• A convenient “doubling rule”

• How long does it take for something to double in size?
• “Rule of 70”:
• If something grows at rate g (%), it takes 70/g for it to double
• g = 5% à 14 years (14=70/5)
• g = 2% à 35 years (35=70/2)
• Implication: At a 2% annual growth rate, income doubles every 35 years

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 The Goal of Economic Growth

• Labor Productivity
• The amount of output a worker turns out in an hour (or a week, or a year) of labor.
• If output is measured by GDP, it is GDP per hour of work.

• Productivity growth is almost everything in long run

• Only rising productivity raises income per capita
• Over long periods of time, small differences in productivity growth rates make a big
difference for a society’s income (prosperity?)
• Reduced poverty
• Public health
• Increased leisure (are we sure?)
• Environmental improvement (are we sure?)

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The Capacity to Produce: Potential GDP and the Production
Function
• Potential GDP
• A measure of the economy’s normal capacity to produce goods and services
• Real GDP the economy would produce if labor and other resources were fully utilized
• Theoretical construct!

• Labor force
• Number of people holding or seeking jobs

• Estimate potential GDP in two steps:

1. Count up the available supplies of labor, capital, and other productive resources
2. Estimate how much output these inputs could produce if they were all fully utilized
• This is an assessment of the economy’s technology
• When is labor not fully utilized?

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The Capacity to Produce: Potential GDP and the Production
Function
• Production function
• Shows how much output can be produced from given inputs with available technology
• What happens to potential GDP if there is technological improvement or more capital?

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Figure 1: The Economy’s Production Function

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
The Capacity to Produce: Potential GDP and the Production
Function
• Production function
• Shows how much output can be produced from given inputs with available technology
• What happens to potential GDP if there is technological improvement or more capital?
• Better technology or more capital increase potential GDP
• What’s the intuition? Think about getting a faster computer…

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 The Growth Rate of Potential GDP

• Growth rate of potential GDP depends on growth rate of inputs to production and technology
• Growth rate of labor force
• Growth rate of capital stock
• Rate of technical progress

• GDP = Output = Hours of work x Output per hour

= Hours of work x Labor productivity

• Growth rate of potential GDP = Growth rate of labor input + Growth rate of labor productivity
• Quality and quantity: More people + More productive people à More potential output

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 The Growth Rate of Potential GDP

• What does the future growth rate look like?

• Growth of labor: 0.50%
• Why slower than in the past?
• Digression: Malthusian traps
• Growth of labor productivity: 1.2% – 1.5%
• Together: Growth rate of potential GDP: 0.5% + 1.5% = 2.0% per year

• Do growth rates of actual and potential GDP match up?

• Over long periods of time: Yes
• Over short periods of time: No (recessions!)
• Great Recession
• COVID-19

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 The Goal of Low Unemployment

• If GDP grows slower (faster) than the economy’s potential…

• Unemployment rate rises (falls)

• Unemployment rate
• (Number of unemployed people) / (Number of people in labor force)

• What is the economic cost of unemployment?

• Goods and services that might have been produced and enjoyed by consumers

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Table 1: The Economic Costs of High Unemployment
Year Civilian Capacity Real GDP Lost
Unemployment Utilization Rate Due to Idle
Rate Resources
1958 6.8% 75.0% 4.8%
1961 6.7 77.3 4.1
1975 8.5 73.4 5.4
1982 9.7 71.3 8.1
1992 7.5 79.4 2.6
2003 6.0 73.4 2.2
2009 9.3 70.0 7.6
2010 9.6 74.3 6.5
2013 7.4 77.3 2.8

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Figure 2: Actual and Potential GDP in the U.S. since 1960

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 The Goal of Low Unemployment

• Cumulative gap between actual and potential GDP

• From 2008 – 2016 (2012 prices) roughly $4 trillion
• Close to three months worth of production at 2017 levels
• This loss cannot be recovered since labor wasted in the past cannot be used in future

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 The Human Costs of High Unemployment

• “In our society, it is murder, psychologically, to deprive a man of a job. . . . You are in
substance saying to that man that he has no right to exist.”
- Martin Luther King, Jr.

• From abstract economic costs of unemployment to human costs

• Economic costs: Output that could have been produced if no unemployment
• Human costs: Psychological and physical disorders, divorces, suicides, crime

• Unemployment rates different for different groups

• Lowest, highest for which groups?

Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Figure 3: Unemployment Rates for Selected Groups

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Unemployment Rates for Selected Groups

• Lots to say about this (good reason to take ECON 336: Labor Economics)
• Some economic research:
• https://pubs.aeaweb.org/doi/pdfplus/10.1257/0002828042002561
• “We study race in the labor market by sending fictitious resumes to help-wanted ads
in Boston and Chicago newspapers. To manipulate perceived race, resumes are
randomly assigned African-American- or White-sounding names. White names
receive 50 percent more callbacks for interviews. Callbacks are also more respon-
sive to resume quality for White names than for African-American ones. The racial
gap is uniform across occupation, industry, and employer size. We also find little
evidence that employers are inferring social class from the names. Differential
treatment by race still appears to still be prominent in the U.S. labor market.”

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Counting the Unemployed: Official Statistics

• BLS survey of 60,000 household classifies persons as:

• Employed
• Everyone currently at work, including part time workers (even 1 hr per week)

• Unemployed
• Temporarily laid-off, expected to return; OR
• Actively looking for a job in last 4 weeks

• Out of the labor force

• Not looking for work

Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Counting the Unemployed: Official Statistics

• Discouraged worker
• Unemployed person who gives up looking for work
• No longer counted as part of labor force

• Disguised unemployment
• Involuntary part-time
• Loss of overtime or shortened work hours
• Discouraged workers

• Does the official unemployment rate over or under estimate unemployment?

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
What’s the right measure of unemployment?

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Measuring discouragement

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Types of Unemployment

Three types of unemployment:

1. Frictional
• Due to normal turnover in the labor market.
• Temporarily between jobs: changing occupations, moving etc.
• Tends to be short term

2. Structural
• Workers who lose jobs because skills are no longer in demand, replaced by automation
• Tends to be long term
• “Deaths of Despair”

3. Cyclical
• Portion unemployment that is due to decline in the economy’s total production
• Rises during recessions; falls during expansions

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Types of Unemployment

Why does it matter what type of unemployment?

• Frictional + Structural à Microeconomic policy problems
• Cyclical à Macroeconomic policy problem

Can cyclical unemployment become structural unemployment?

• Great Recession…
• …so maybe the micro-macro delineation is not perfect for policy-makers.

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 How Much Employment is “Full Employment”

• “Full employment”
• Everyone who is willing and able to work can find a job
• Unemployment rate is still positive
• Always frictional and structural
• 2012 estimate: 5.2% - 6.0%
• 2018 estimate: 4.0% - 5.0%

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 Unemployment Insurance: The Invaluable Cushion

• Unemployment insurance:
• Program that replaces some wages lost by eligible workers who lose their jobs
• Administered by the states under federal guidelines
• Average weekly benefit in 2017 was $323, 36% earnings
• Normally last for 6 months
• Extended to 99 weeks during Great Recession

• Goals:
• Help macroeconomy:
• Limits the severity of recessions by providing additional purchasing power
• Aggregate demand does not fall as much
• Reduce hardship

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Unemployment Insurance: The Invaluable Cushion

• Payroll taxes and unemployment benefits

• Spread the cost of unemployment over the entire population
• But basic economic cost of lost output still exists

• Highly-contentious policy
• What are some potential risks of paying higher unemployment benefits?
• What are some of the potential benefits?

• COVID-19:
• CARES Act
• FPUC à Extra $600/week
• PEUC à Benefit duration extended by 13 weeks
• PUC à Expand eligibility (e.g. gig workers)
• COBOL Cowboys

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 The Goal of Low Inflation

Does a decrease of purchasing power make everyone worse off?

• Purchasing power: The volume of goods and services that a given amount of money will
buy

• Real wage rate:

• Wage rate adjusted for inflation.
• The volume of goods and services that nominal wages will buy

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Figure 4: Rates of Change of Wages and Prices in the
U.S. since 1948

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 The Goal of Low Inflation

Does a decrease of purchasing power make everyone worse off?

• In the long run real wages increase because:

• New capital equipment and innovations increase workers’ productivity…
• …and productivity growth is what matters.

• So why do many people believe that inflation erodes real wages?

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Why do many people believe that inflation erodes real wages?

Reasons for Wage Increase Amount

Higher productivity 2%
Compensation for higher prices 3%
Total 5%

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 The Goal of Low Inflation

Another common misperception is the failure to see the difference between:

• A rise in general price level
• An increase in relative prices
• An item’s price in terms of some other item

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 Table 2: Pure Inflation
Item Last Year’s Price This Year’s Price Increase
Candy Bar $2.00 $2.20 10%
Movie Ticket $10.00 $11.00 10%
Automobiles $20,000 $22,000 10%

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 Table 3: Real World Inflation
Item Last Year’s Price This Year’s Price Increase
Candy Bar $2.00 $2.00 0%
Movie Ticket $10.00 $12.50 25%
Automobiles $20,000 $21,000 5%

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 The Goal of Low Inflation

• With pure inflation of 10%:

• 1 ticket = 5 candy bars
• 1 car = 2,000 tickets

• With average inflation of 10%

• 1 ticket = 6.25 bars
• 1 car = 1,680 tickets

• Who gains and who loses?

• Inflation is not usually to blame when some goods become more expensive relative to
others

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 Inflation as a Redistributor of Income and Wealth

• The average person is neither helped not harmed by inflation.

• What about senior citizens on fixed income?
• What about minimum wage workers in polarized political climate?

• Inflation does cause redistribution

• Lenders lose since the dollars they receive back are worth less in real terms
• Borrowers gain since the dollars they pay back are worth less in real terms

• Inflation redistributes in an arbitrary way

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 Real Versus Nominal Interest Rates

• Go back to lender/borrower argument. What have we missed?

• Expected inflation versus unexpected inflation

• Two interest rates:

• Real rate of interest
• Percentage increase in purchasing power that the borrower pays to the lender for the
privilege of borrowing
• Indicates the increased ability to purchase goods and services that the lender earns
• The borrower needs to compensate the lender for giving up current consumption

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Real Versus Nominal Interest Rates

• Two interest rates (cont’d):

• Nominal rate of interest
• Percentage by which the money the borrower pays back exceeds the money that
was borrowed
• Making no adjustment for any decline in the purchasing power of this money that
results from inflation
• The borrower needs to compensate the lender for the loss in purchasing power

Nominal interest rate = Real interest rate + Expected inflation rate

Real interest rate = Nominal interest rate - Expected inflation rate

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 Real Versus Nominal Interest Rates

• When does inflation cause a redistribution from borrower to lender? From lender to borrower?

• An example:
• Suppose Kim lends Matt $100 for one year
• To compensate her for giving up $100 for one year, she wants to be paid back 5% in real terms
• Matt and Kim expect an inflation rate of 3%
• Nominal interest rate = 5% + 3% = 8%
• Suppose at the end of the year:
• Inflation turns out to be higher than expected: 6% > 3%
▶ In real terms, Matt pays back 2% interest: 8% - 6%

▶ Matt (borrower) gains and Kim (lender) loses

• Inflation turns out to be lower than expected: 1% < 3%

▶ In real terms, Matt pays back 7%: 8% - 1%

▶ Kim (lender) gains and Matt (borrower) loses

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Real Versus Nominal Interest Rates

The general principle:

• If the expected rate of inflation < actual rate of inflation

• Lenders lose and borrowers gain

• If the expected rate of inflation > actual rate of inflation

• Lenders gain and borrowers lose

• If the expected rate of inflation = actual rate of inflation

• Inflation creates no distortion

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Inflation Distorts Measurements

• Confusing real and nominal interest rates:

• In 1980, mortgage rates were 12% with 10% inflation à 12%-10% = 2% real interest rate
• In 2016, mortgage rate were 3.5% with 1.5% inflation à 3.5%-1.5% = 2% real interest rate
• Which is a better bargain?

• Malfunctioning tax system

• Taxes paid on nominal interest earned and nominal capital gains.
• Thus, taxes are high when inflation is high…
• …which discourages saving and investment and thus reduces economic growth

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Other Costs of Inflation

• Long term contracts become riskier

• Nominal rate = Real Rate + Expected Inflation
• If prices rapidly rising, more difficult to predict what the actual inflation rate will be…
• …which leads to less lending and less borrowing…
• …which leads to less investment and less economic growth.

• Shopping by consumers and firms

• If prices rising, need to shop around more
• “Shoe leather” costs
• In extreme cases, this can be extremely wasteful (see group project ideas!)

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 The Costs of Low Versus High Inflation

• Steady inflation
• More predictable than variable inflation
• Smaller social and economic costs

• Average level of inflation

• Steady inflation of 6% per year, worse than steady inflation of 3% per year?
• Maybe (see previous slides)…
• …but maybe not (how could high inflation help in a recession?)

• Hyperinflation
• Very high inflation
• Weimar Germany, Argentina, Venezuela, etc.
• What leads to “hyperinflation”? Is it likely now?

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 Inflation today

Today we learned:

• Is this cause for concern?

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Appendix

How Statisticians Measure Inflation

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Index Numbers for Inflation

• Price index
• Expresses the cost of a “market basket” of goods relative to its cost in some “base”
period

• Consumer Price Index (CPI)

• CPI in given year = 100 x (Cost of market basket in given year) / (Cost of market basket
in base year)

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Index Numbers for Inflation

• Consumer Price Index

• Cost of market basket in base year (1982-1984) = $2,000
• Cost of market basket in 2017 = $4,900
• CPI in base year = 100 (by definition)
• CPI in 2017 = ($4,900 / $2,000) x 100 = 245

• Index number problem

• No “perfect price index” that is correct for every consumer when relative prices change
• Any statistical index will either understate or overstate the increase in cost of living for
other families
• Index: “Average” family

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Consumer Price Index

The CPI is measured by pricing the items on a list representative of a typical urban household

• Simple example: “Student Price Index” or SPI

• Hamburgers, jeans and movies
• By how much has a student’s cost of living increased from 1987-2017?

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Table 4: Results of Student Expenditure Survey in 1987

Item Average Price Average Quantity Average

Purchased per Expenditure per
Month Month
Hamburger $0.90 70 $63
Jeans $24.00 1 $24
Movie Ticket $5.00 4 $20
Total $107

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 Table 5: Prices in 2017

Item Price Increase over

1987
Hamburger $1.20 30%
Jeans $30.00 25%
Movie Ticket $7.00 40%

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Table 6: Cost of 1987 Student Budget in 2017 Prices

Item Price
70 hamburgers at $1.20 $84.00
1 pair of jeans at $30 $30.00
4 movie tickets at $7.00 $28.00
Total $142.00

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 Student Price Index

• By how much has a student’s cost of living increased from 1987-2017?

• Cost in 1987 was $107
• Cost in 2017 was $142
• In general:
• SPI (2017) = 100 x (Cost of budget in 2017) / ( Cost of budget in 1987)
= 100 x ( $142 ) / ( $107 )
= 132.7

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Using a Price Index to “Deflate” Monetary Figures

• Deflating
• Process of finding the real value of some monetary magnitude by dividing by some
appropriate price index
• Suppose the average student spent $107 per month in 1987 but $140 per month in 2017
• Are students today, spending more or less in real terms?
• Real spending in 2017 = (Nominal spending in 2017 / Price Index of 2017) x 100
= ($140 / 132.7) x 100 = $105.50
• So in real terms students spend less today than in 1987
▶ $105.50 < $107

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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Using a Price Index to Measure Inflation

• Inflation
• Rate of increase in price level
• Example #1: CPI in 1973 = 44.4, CPI in 1974 = 49.3
• CPI in 1974 / CPI in 1973 = 49.3/44.4 = 1.11
• Inflation rate = 100*(1.11 - 1) = 11%

• Example #2: CPI in 2016 = 240, CPI in 2017 = 245.1

• CPI in 2017 / CPI 2016 = 245.1/240 = 1.021
• Inflation rate = 100*(1.021 - 1) = 2.1%

Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 GDP Deflator

• The price index used to deflate nominal GDP

• Broad measure of economy-wide inflation
• Includes the prices of all goods and services in the economy
• Real GDP = 100 x (Nominal GDP) / (GDP Deflator)
• May be a better measure of inflation since much broader “basket” of goods

Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition. © Cengage. All Rights Reserved. May
not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.