Lecture 23

We tend to overestimate the rate of inflation and underestimate the rate of real economic growth when we consider the fact that earlier, people did not have modern conveniences.
As a result, to compensate for the shift in base year prices, we chain weight to average the prices.

The GDP deflator or implicit price deflator is the ratio of the nominal GDP to the real GDP. It gives a measure of the price of output relative to its price in the base year. It reflects the level of prices in the economy (and not quantities).
Observe that the GDP deflator is equal to \(1\) in the base year.

Inflation is used to describe a situation where the economy’s price level is increasing. The inflation rate is the percentage change from one period to the next. It can be calculated as the percentage change of the GDP deflator.

We must take inflation into account when calculating the GDP. Further, it becomes difficult to compare different countries since the degree of inflation is different in different countries.

Some problems in comparing GDPs are:

• GDP is understated due to the informal sector.
• Household scale economies are not taken into account.
• Exchange rates to convert the GNP in local currency to USD is based on relative prices of internationally traded goods.
• In developing countries, many cheap, labour-intensive, unstandardized goods and services have no impact on the exchange rate as they are not traded.
• The price of foreign exchange is less than the equilibrium/market clearing price due to import barriers, restrictions on access to foreign currency, export subsidies, or state trading.
• Resistant services such as healthcare and government administration which comprise more than 10% of most countries’ expenditures distort cross-national comparisons.

The (real and nominal) per capita GDPs are of interest and per capita growth should be looked at as well.

To resolve the problems in comparing GDP, we look at purchasing power parity. How much does a particular product cost in dollars in different countries? For example, a Starbucks grande latte costs $9.83 in Oslo but $2.80 in New Delhi.
We want a dollar to have the same purchasing power in any country.