Week 2 Lectures - The Cost of Living

Question 1

State the formula used to calculate the GDP deflator at date t

Answer 1

GDP deflator at date t = Nominal GDP at date t / Real GDP at date t

Question 2

What is the GDP deflator an example of?

Answer 2

The GDP deflator is an aggregate price index

Question 3

What is meant by the inflation rate?

Answer 3

The inflation rate is equal to the relative change in a price index

Question 4

What is the Consumer Price Index (CPI)?

Answer 4

The CPI measures the overall level of prices of goods and services bought by consumers by computing the cost of a fixed basket of goods in different years

Question 5

Explain step by step how to calculate the CPI

Answer 5

1- Determine the fixed basket of goods: The prices which are most important to the typical consumer are found out by using ONS surveys explaining what the typical consumer buys. The goods which are bought in higher quantities by consumers are given a higher weight in the index as a result.
2- Find the prices of the goods at each point in time
3- Compute the basket’s cost by multiplying price by quantities for each year to get the total cost of the basket for that year
4- Choose a base year and compute the CPI (the base year is the benchmark) using the following formula: Price of basket of goods and services in the current year / Price of basket in base year*100
5- Compute the inflation rate using the following formula:
Inflation rate in year 2 = CPI in year 2 - CPI in year 1 / CPI in year 1 *100

Question 6

How is the CPIH different to the CPI and what does the H stand for?

Answer 6

• The CPIH includes owner and occupier’s housing costs as well as council tax
• The H stands for Housing

Question 7

Compare which of the CPI or CPIH is a better measure of ‘cost of living’

Answer 7

The CPI does not include mortgage interest payments and council tax so the CPIH is a better measure of ‘cost of living’ than the CPI

Question 8

What is the Producer price index (PPI)?

Answer 8

The PPI is a measure of the cost of a basket of goods and services bought by firms

Question 9

What is the relationship between the CPI and the PPI?

Answer 9

Changes in the PPI are often thought to be useful in predicting changes in the CPI as firms usually pass on their costs to consumers in the form of higher prices

Question 10

Explain the relevancy of personal price indices

Answer 10

Personal price indices have always been relevant but have become especially relevant these days due to high inflation

Question 11

What are the drawbacks of the CPI?

Answer 11

1- There is substitution bias: Some good’s prices rise by more than others and some even fall which leads to consumers substituting towards goods that have become relatively less expensive but the problem occurs as the CPI assumes a fixed basket of goods and so it overstates inflation
2- Introduction of new goods: A greater variety of goods makes a pound more valuable so the cost of living has declined but the basket of goods in the index is updated only at a lag
3- Unmeasured quality change: Prices need to be adjusted to reflect quality changes (when a good becomes better its price has effectively fallen as your pound goes further)
4- The basket that a given individual buys is not necessarily the CPI basket

Question 12

Compare the GDP deflator and the CPI/PPI

Answer 12

GDP deflator:
1- It is the ratio of nominal GDP to real GDP
2- It reflects prices of all goods and services produced domestically
CPI/PPI:
1- It reflects prices of goods and services bought by consumers/firms

Question 13

Do the GDP deflator and CPI inflation always have to be the same?

Answer 13

The GDP deflator and CPI inflation can differ as for example if oil prices rise, CPI inflation in the UK goes up by more than the GDP deflator because oil makes up a larger share of consumer spending than of GDP

Question 14

State the formula used to compare the value of a £ in different years

Answer 14

Amount in today’s £ = Amount in year T £*Price level today/Price level in year T

Question 15

What is Real GDP per person a measure of?

Answer 15

Real GDP per person is a measure of living standards

Question 16

When asked to calculate growth rate what must we always check first?

Answer 16

Check whether we are calculating the growth in real GDP per person or in real or nominal GDP

Question 17

What are the different proximate causes of long-run economic growth?

Answer 17

• Productivity
• Capital stock
• Schooling
• Capital investment
• Diminishing returns
• Human capital investments
• Health and Nutrition
• Research and development
• Population growth

Question 18

Define productivity

Answer 18

Productivity is the quantity of goods and services produced from each unit of labour input

Question 19

What is the relationship between productivity and GDP growth?

Answer 19

Productivity growth is the key determinant of GDP growth, hence living standards as salary increases tend to follow productivity increases

Question 20

What are the determinants of productivity?

Answer 20

1- Physical capital: This includes the stock of equipment and structures used to produce goods and services
2- Human capital: This includes knowledge and skills that workers acquire through education, training and experience
3- Natural resources
4- Technological knowledge: Society’s understanding of the best ways to produce goods and services

Question 21

Write the general production function for productivity

Answer 21

Y = A F(L,K,H,N)
- Y is output
- L is the quantity of labour
- K is the quantity of physical capital
- H is the quantity of human capital
- N is the quantity of natural resources
- A reflects the level of available technology
- F is the function that shows how these inputs are combined to produce output

Question 22

What type of cause would an increase in any variable in the productivity production function cause?

Answer 22

An increase in any of the variables involved in the productivity production function would be a proximate cause of growth

Question 23

What steps would need to be taken in order to increase capital investment and what is the trade-off caused by increasing capital investment?

Answer 23

• To increase capital investment economic agents would need to save more currently to finance this future investment in capital
• To invest more in capital, a society must consume less now to save more of its current income

Question 24

What is meant by capital investment being subject to diminishing returns?

Answer 24

• The benefit from an extra unit of K declines as the quantity of the input increases
• Therefore in the long run, the higher the savings rate the higher investments and capital will be but the effect will be a smaller increase in output over time

Question 25

Draw a diagram to demonstrate the decreasing marginal product of capital

Answer 25

*See slide 25 in the Week 2 lecture*

Question 26

Compare the effects of capital investment on poor and rich countries

Answer 26

- Countries that start off poor tend to grow more rapidly than countries that start off rich as poor countries have low productivity so even small amounts of capital investment increase worker's productivity substantially - Rich countries already have high productivity so additional capital investment has a small effect on productivity

Question 27

How does increased health and nutrition increase productivity?

Answer 27

- Healthier and stronger workers are more productive - Robert Fogel found that improved nutrition explains about a 1/3 of income growth per capita in the UK from 1790 to 1980

Question 28

How can research and development (the A in the production function) be increased in order to increase productivity?

Answer 28

The government can encourage research and development via publicly operated research institutes, grants etc or enforce a patent system which increases the incentive to undertake R&D

Question 29

How do institutions foster economic growth?

Answer 29

- Institutions give people the ability to protect their property rights and exercise authority over the resources they own - Institutions also prevent damaging instability and promote political stability

Question 30

What are the drawbacks of a lack of property rights?

Answer 30

A lack of property rights means that: - Contracts are hard to enforce - Fraud goes unpunished - Corruption - Domestic saving is discouraged - Investment from abroad is discouraged

Question 31

What are the drawbacks of political instability?

Answer 31

Political instability causes: - Threat to property rights - Revolutions and coups - Domestic residents have less incentive to save, invest and start new businesses - Foreigners have less incentive to invest

Question 32

What are the benefits and drawbacks of population growth in terms of stimulating economic growth?

Answer 32

- Population growth means that there are more workers to produce goods and services so there is a larger total output of goods and services - High population growth dilutes the capital stock meaning there is lower productivity per worker - It puts pressure on natural resources