Our first article in this series on macroeconomics covered GDP (Gross Domestic Product). We made a distinction between nominal GDP and real GDP based on the effects of increasing or decreasing prices. Today, we are going to expand on that topic: this article will introduce you to inflation and growth.
Inflation can be defined as a sustained rise in the price level. Deflation would be the opposite phenomenon. The rates at which the price level increases (or decreases) are called inflation rate and deflation rate. Remember: real GDP is the result of correcting the effects of increasing or decreasing prices. In other words, GDP becomes real once we account for inflation.
There are two ways to measure the changes in the price level. The first way is by using the GDP deflator, because it uses both nominal and real GDP to calculate the final value. The second way to measure inflation is by calculating the Consumer Price Index (every country has its own acronym for CPI).
The GDP deflator is the result of a fairly simple division:
As you can see in the equation, the GDP deflator uses one year as reference (taken from real GDP), so the value in year t will be equal to 1 (some people use 100). The reference year can be any year; it is the rate of change that matters. If the value increases (Pt+1 > Pt) with time, that means the price level is increasing. If the value decreases (Pt+1 < Pt), the price level is decreasing. Bear in mind that GDP is a measure of aggregate output. Be careful! This index does NOT include goods and services that are imported from abroad.
Because consumers don’t care about all final goods in an economy, there is another way to estimate inflation. The Consumer Price Index (CPI) measures the average price of consumption (i.e. the average price of goods we consume). The prices of goods like industrial equipment or components are not included in this index.
Unfortunately, there is no easy formula for this one. CPI is a representative of all the goods and services available for purchase by consumers. Such a difficult task requires a lot of variables: the CPI uses a basket of goods and services, and it’s usually a big one. Good news is, CPI is also an index, just like the GDP deflator, so it can be interpreted very easily as well.
Both the GDP deflator and the CPI tend to move together. This statement may look obvious, and most of the time, it is true. But both indices moving together doesn’t mean they have to move together. In fact, there have been a few exceptions during the last few years, especially in times where the gap between imports and exports becomes more noticeable. We’ll talk about open economies later, but I’m leaving this here for reference: if the dollar depreciates against the euro, imports by the US will be cheaper for European citizens, making the US GDP deflator increase more than the US CPI (and vice versa for the EU!).
Why growth rates are so important
Being able to calculate your country’s GDP or CPI is nice, but economists focus even more on growth rates than they do on the values themselves. Growth rates tell us how the macroeconomic indicators are doing compared to previous months or years. The formula is the same for every indicator:
This way, we will be able to know at what pace our indicators are increasing (or decreasing!). Let’s see some real examples of changes in the GDP and the price level:
As you can see in the graphs, both aggregate output and prices can increase or decrease, slowly or quickly. “-5.91% growth for 2020” means that the real GDP in the USA will be (more or less, since that number is an estimate) 5.91% less than it was in 2019. Similarly, an estimated inflation rate of 0.62% for 2020 means that the price level will be 0.62% higher than it was in 2019.
Knowing how the indicators change year-to-year makes it easier for all economic agents to make decisions, and can help policy makers take action if the estimates are not as good as they could be – this is why economists pay close attention to growth rates.
Usually, inflation and economic growth go hand in hand. In our next article, we will try to dig deeper into this relation between the two phenomena and explain why inflation is not a bad thing in itself. If you want to learn more about inflation, take a look at the charts yourself! Both the BEA (United States) and the ECB (European Union) have a lot of updated information on inflation, GDP growth and much more. Doing some research will help you a lot with understanding real macroeconomics 🙂