EC201 Intermediate Macroeconomics

2011/2012

EC201 Intermediate Macroeconomics

Lecture 2: National Accounting

Lecture Outline:
-

How to measure economic activity (GDP, Inflation rate, Unemployment rate,

etc. etc.);

Important identities in national accounting;

Issues in aggregate income distribution;

Essential reading:
Mankiw: Ch. 2 and 3
National Accounting
When we talk about national accounting we talk about measuring the total quantity of
goods and services produced in an economy in a given period of time.
In the previous lecture we have seen the series of real GDP per capita in the US. To
create that series we need to create data and therefore we need to define what is the
GDP and how to calculate it.
GDP (Gross Domestic Product): the value of final output produced during a given
period of time within the borders of a given country.
Within the boarders means that if a firm is located in UK but the ownership is in
France, the production of that firm located in UK will be counted in the GDP of UK
and not in the GDP of France.
There are three approaches to measuring GDP, and all give exactly the same measure
of GDP:
1) Product approach (or value-added);
2) Expenditure approach;
3) Income approach;
To see how all these approaches work we consider a simple example.
Consider a very simple economy where there is a coconut producer, a restaurant,
some consumers and a government.

The coconut producer: owns all the coconut trees, harvests the coconuts and in
current year produces 10 million coconuts which are sold for $2 each, yielding total
revenue of $20 million.
He pays $5 million to his workers, $0.5 million in interest on a loan to some
consumers and $1.5 million in taxes to the government.
The following table summarises those data:
Table 1

Coconut Producer

Total revenue

$20 million

Wages

$5 million

Interest on Loan

$0.5 million

Taxes

$1.5 million

The restaurant: of the 10 million coconuts produced, 6 million go to the restaurant

that uses them to produce meals that are sold to the consumers. In this case the
coconut represents an Intermediate Good, a good that is produced and then used as
an input to another production process. All coconuts cost $2 therefore the total cost
for the restaurant from buying them is $12 million.
The remaining 4 million coconuts go to the consumers.
The restaurant sells $30 million in meals during current year. This represents its total
revenues.
The restaurant pays its workers $4 million and pays $3 million in taxes.
Table 2

Restaurant

Total revenue

$30 million

Wages

$4 million

Taxes

$3 million

Now define the following:

After tax profits = Total Revenue Wages Interest Cost of intermediate goods
Taxes
This is what is left to the producer and the restaurant after costs and taxes have been
paid. Using the data from the previous tables we have:
After tax profits: 50 9 0.5 12 4.5 = $24 million
$24 million are the after tax profits of the two firms in the economy (the coconut
producer and the restaurant). It does matter for our calculations how much of the $24
million goes to the owner of the restaurant and how much to the coconut producer.

Consumers: work for the producer of coconuts, the restaurant and the government
(notice that the owner of the restaurant and the producer of coconuts are consumers as
well). They earn $9 ($5+$4) million from the producer and the restaurant and $5.5
million from the government. They receive $0.5 million from interest on a loan to the
producer and $24 million of after tax profits. They consume directly 4 millions of
coconuts (10 millions minus the 6 millions sold to the restaurant).
Furthermore, they pay $1 million in taxes.
Table 3

Consumers

Wage Income

$14.5 million

Profits distributed

$24 million

Interest Income

$0.5 million

Taxes

$1 million

Government: it collects taxes to provide national security (military) to the economy.

It pays the army using the taxes collected. We assume no deficit (balanced budget),
and therefore total tax collected (=$5.5 million) is equal to total spending.
Table 4

Government

Total revenue

$5.5 million

Wages

$5.5 million

1) The product approach (or value added).

In this approach, to calculate the GDP: we add the value of all goods and services
produced and then subtract the value of all intermediate goods used in production.
We subtract the value of the intermediate goods to avoid double counting in the
calculation.
Using this approach the GDP is simply defined as the sum of value added to goods
and services across all productive units in the economy.
From our example: the coconut producer does not use any intermediate good,
therefore the value added of his production is $20 million (his total revenues).
For the restaurant, the value added is its total revenues minus its cost of intermediate
goods: $30 million $12 million = $18 million.
Also the government is producing something (national security) and therefore we
need to include that in our calculations. However, we have a problem here. We dont
have a price for the good National Security (classical example of a public good).
The standard practice in this case is to evaluate the national security services at the

cost of the inputs to production. In our case, the only input was labour, and the total
cost was $5.5 million. Therefore the value added for the government is $5.5 million.
Using the production approach (or value added), the value of the GDP in our
economy for the current year is:
GDP = 20 + 18 + 5.5 = $43.5 million
2) The expenditure approach
Here the GDP is defined as: the total spending on all final goods and services
produced in the economy in a given period of time.
Notice: the word final in the definition implies that WE DO NOT COUNT spending
on intermediate goods.
What is total expenditure?
Total Expenditure = C + I + G + NX
C is total expenditure in consumption
I is investment expenditure
G is government expenditure
NX is net exports (= Exports in goods and services Import in goods and services)
We include exports because they are produced within the country we are considering
and we subtract imports because goods produced abroad are included in C, I and G
and we dont want to include them in the calculation of GDP (remember within
borders). In some models we will see we shall consider the case of a closed
economy. By definition, a closed economy is an economy that does not have trade
with other countries, therefore, NX=0 in this case. We will do this because it is
simpler to analyse a closed economy than an open economy.
From our example, using the expenditure approach we have that I = 0 and NX = 0.
There is no investment in our example and no international trade.
The GDP is then given by: C + G
Total consumption is $38 million, $8 million on coconuts and $30 million at the
restaurant. Government expenditure is $5.5 million.
Therefore: GDP=C+I+G+NX=$43.5 million
3) The Income approach
In this case the GDP is defined as the sum of all income received by economic agents
contributing to production.
Income includes the profits of firms.

The income of the consumers is $14.5 million in wages. Then we need to add $0.5
million of income on the interest on a loan. Then we need to include the income given
by profits after tax of $24 million. Finally we need to include the taxes paid by the
producers since they are income for the government. We do not include the taxes paid
by consumers since they are receiving back those taxes as wages (this is just a transfer
and not a contribution to production).
Using this method: GDP = 14.5 + 0.5 + 24 + 4.5 = $43.5 million
Therefore, the GDP is equivalent to the total income in the economy. Let Y denoting
the total income of the economy, using the definition of the total expenditure we have:
Y = C + I + G + NX

This IDENTITY is called Income Expenditure identity.

It is the basic identity in national accounting.
The idea is: the total quantity produced (Y) in an economy must be ultimately sold.
The different components of aggregate expenditure:
a) Consumption: the value of all goods and services bought by households
It includes:
durable goods: last a long time, ex: cars, home appliances
nondurable goods: last a short time, ex: food, clothing
services: work done for consumers, ex: dry cleaning, air travel.
b) Investment: spending on new capital (the factor of production)
It includes:
business fixed investment: Spending on plant and equipment that firms will use to
produce other goods & services.
residential fixed investment: Spending on housing units by consumers and landlords.
inventory investment: The change in the value of all firms inventories.
c) Government spending: includes all government spending on goods and services.
It excludes transfer payments (e.g., unemployment insurance payments, pensions),
because they do not represent spending on goods and services.
d) Net Exports: The value of total exports (X) minus the value of total imports (M).
Suppose now that a firm:

produces $10 million worth of final goods

but only sells $9 million worth.

Does this violate the expenditure = output identity?

The answer is NO, because unsold output adds to inventory, and thus counts as
inventory investment whether intentional or unplanned.

Thus, its as if a firm

purchased its own inventory accumulation. We have just seen the inventory enters
in the definition of Investment and therefore they counted as expenditure.
To summarise: we have now seen that GDP measures

total income

total output

total expenditure

the sum of value-added at all stages in the production of final goods

Another measure of total income:

The GDP is the most used measure for total income of an economy. However, there
are other measures of total income that can be used:
Gross National Product (GNP) = GDP + Net Factor Payments (NFP)
The GNP measures the value of output produced by domestic factors of production,
regardless of whether the production takes place. Remember that the GDP instead
measures total income earned by domestically-located factors of production,
regardless of nationality
Net factor payments = factor payments from abroad factor payments to abroad.
For example, if a UK firm is managed by Italian residents, then the profits created by
this firm will be counted in the Italian GNP but not in the Italian GDP.
In general the difference between GDP and GNP is not particularly large.
Another way to write the income-expenditure identity
The income-expenditure identity implies
Y = C + I + G + NX

Define with YD the disposable income of the private sector:

Y D = Y + NFP T
where Y is the aggregate income, NFP are the net factor payments from abroad and T
are the taxes. (There may be other factors that affect the disposable income, for
example, the interest rate households obtain from government bonds, the transfer of
money from government, etc. etc.. Adding those elements will not affect the final
result)
Private Saving is then defined as:

SP = YD C
Government saving is defined as:

SG = T G
If SG is positive, the government is running a surplus, while if its negative its
running a deficit.
The National Saving is then defined as:

S = S P + SG = Y D C + T G

1)

By the definition of Y D , we have that Y D + T = Y + NFP

Therefore, we can rewrite equation 1) as
S = Y + NFP C G

2)

Substitute into 2) the definition of Y given by the Income-Expenditure identity:

S = C + I + G + NX + NFP C G = I + NX + NFP

Thus, national saving must be equal investment plus net exports plus net factor
payments from abroad.
The quantity NX + NFP is called Current Account (CA), it is a measure of the
balance of trade in goods and service with other countries.
Therefore, our income-expenditure identity can be written also as:

S = I + CA
In a closed economy, where NX = 0, and NFP = 0, the income-expenditure identity
implies: S = I
National saving must be equal to aggregate investment.
Real vs. nominal GDP
GDP is the value of all final goods and services produced.
nominal GDP measures these values using current prices.
real GDP measure these values using the prices of a base year.
Changes in nominal GDP can be due to:

changes in prices.

changes in quantities of output produced.

Changes in real GDP can only be due to changes in quantities, because real GDP is
constructed

using

constant base-year prices.

Real GDP is a better measure of the well-being of an economy. Suppose that all the
prices of goods double. Then the GDP will double as well, however, quantities are the
same of before, therefore, the economy is not better-off even if the GDP has double.

How to compute nominal and real GDP:

2006

2007

2008

good A

$30

900

$31

1,000

$36

1,050

good B

$100

192

$102

200

$100

205

nominal GDP: multiply Ps & Qs from same year

2006: $46,200 = $30 900 + $100 192
2007: $51,400
2008: $58,300
real GDP

multiply each years Qs by 2006 Ps

2006: $46,200
2007: $50,000
2008: $52,000 = $30 1050 + $100 205
Notice that Real GDP in 2007 and 2008 is lower than GDP in those years. This is
because the price effect (inflation) has been taken out by using a base year for the
prices (2006).
Notice that the choice of the base year matters for calculations.
For example, if we choose 2007 as the base year, the real GDP in 2007 is $51,400,
while in 2008 is $53,460.
Inflation Rate
The inflation rate is the percentage increase in the overall level of prices.
One measure of the price level is the GDP deflator, defined as:

GDP deflator = 100

Nominal GDP
Real GDP

Using the same example as before:

Nominal GDP Real GDP

GDP

Inflation

deflator

rate

2006

$46,200

$46,200

100.0

n.a.

2007

51,400

50,000

102.8

2.8%

2008

58,300

52,000

112.1

9.1%

Notice that the GDP deflator identifies an index that measures the overall price
LEVEL in a given year.
Inflation rate is the rate of change of that index from one year to the following.

Example with 3 goods

For good i = 1, 2, 3
Pit = the market price of good i in month t
Qit = the quantity of good i produced in month t
NGDPt = Nominal GDP in month t
RGDPt = Real GDP in month t

GDP deflatort =

NGDPt = P1t Q1t + P2t Q2t + P3t Q3t

RGDPt
RGDPt

Q 1t
Q 2t
Q 3t
=
P1t +
P2t +
P3t
RGDPt
RGDPt
RGDPt

The GDP deflator is a weighted average of prices.

Qit
The weight
RGDPt

on each price reflects that goods relative importance in GDP.

Note that the weights change over time

Another measure for the inflation rate: CPI
CPI = Consumer Price Index
It is based on a fixed basket of goods that are normally an important part of
households consumption.
CPI in any month equals:
100

Cost of basket in that month

Cost of basket in base period

Example with 3 goods

For good i = 1, 2, 3
Ci = the amount of good i in the CPIs basket
Pit = the price of good i in month t
Et = the cost of the CPI basket in month t
Eb = the cost of the basket in the base period

CPI in month t =

Et
P C + P2t C2 + P3t C3
= 1t 1
Eb
Eb

C
C
C
= 1 P1t + 2 P2t + 3 P3t
Eb
Eb
Eb
The CPI is a weighted average of prices.
The weight on each price reflects that goods relative importance in the CPIs basket.
Note that the weights remain fixed over time.
CPI vs. GDP Deflator
prices of capital goods

included in GDP deflator (if produced domestically)

excluded from CPI

prices of imported consumer goods

included in CPI

excluded from GDP deflator

the basket of goods

CPI: fixed

GDP deflator: changes every year

In the following figure we plot the CPI and the GDP deflator for the US economy
from 1950 to 2005.

10

15%
12%
9%
6%
3%
0%
-3%
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

GDP deflator

CPI

Although the two series display a similar pattern, there are some relevant differences
in some years. Those differences are due to the elements we listed in the previous
page. In general the CPI index is the most common way to measure inflation. This is
because it is based on the consumption of households and therefore is a better
measure of the cost of living in an economy.
By its construction the CPI index may overstate the rate of inflation:
Introduction of new goods: The introduction of new goods makes consumers better
off but it does not reduce the CPI, because the CPI uses fixed weights.
Unmeasured changes in quality: Quality improvements increase the value of the
dollar, but are often not fully measured.
Unemployment Rate
Categories of the population (POP)

Employed (E): working at a paid job

Unemployed (U): not employed but looking for a job

Labour Force (L): the amount of labour available for producing goods and
services; all employed plus unemployed persons

not in the labour force (NILF): not employed, not looking for work (for
example, full-time students)

unemployment rate: percentage of the labour force that is unemployed.

U.S. adult population by group, June 2007

11

Number employed

146.1 million

Number unemployed =

6.9 million

Adult population

231.7 million

E = 146.1, U = 6.9, POP = 231.7

L = E +U = 146.1 + 6.9 = 153.0
NILF = POP L = 231.7 153 = 78.7
unemployment rate
U/L x 100% = (6.9/153) x 100% = 4.5%
Stock Variables vs Flow variables
It is sometimes important to distinguish between those two kinds of variables.
A stock is a quantity measured at a point in time.

E.g.,
The U.S. capital stock was $26 trillion on January 1, 2006.
A flow is a quantity measured per unit of time.

E.g., U.S. investment was $2.5 trillion during 2006.

It is often the case that a flow variable measures the rate of change in a corresponding
stock variable. Here are some examples:
Stock
a persons wealth

n. of people with college degrees

the govt debt

Flow
a persons annual saving
n of new college graduates this year
the govt budget deficit

The Neoclassical theory of income distribution

We consider a closed economy. When we consider income distribution in a given
economy we may look at the personal distribution of income. In this case we talk how
income is distributed to the population of the economy. For example, 50% of UK
population holds 93% of the total income of UK. We can also talk about the

functional distribution of income. In this case we want to know how the aggregate
income is divided among the factors of production, meaning, workers, owners of
capital (capitalists) and owners of land etc. etc. Here we consider the issue of the
functional distribution of income. Our main question is: what determines the
economys total output/income and how total income is distributed among the factors
of production?
In defining the GDP from an accounting point of view we have seen what an
economy produces. It produces consumption goods, investment goods ect. etc.

12

Now we ask: how we produce those goods. The economys output of goods and
services depends on the quantity of inputs (or factors of production) and the ability to
turn inputs into output. In economics the way inputs are transformed into outputs is
defined by a production function. Here we will consider only two inputs, labour and
capital. So our problem is to find how aggregate income is divided between workers
and capitalists.
Define with Y the total output produced (real output) and with K and L the amount of
inputs available in the economy. K is for the level of Capital and L for Labour.
A production function is defined as:

Y = F ( K , L)
The inputs K and L are transformed into Y through the function F. The production
function reflects the available technology for turning capital and labour into output.
On of the main properties of a production function is related to the concept of Returns
to Scale. When we talk about changing the scale we talk about the effects on output of
changing ALL the inputs of production (therefore, we may assume we are in the longrun). Mathematically, the idea of returns to scale is related to the idea of homogeneity
of a function. A function f(X) is homogeneous of degree k if its true that:

f ( rX ) = r k f ( X )
where r is a constant.
Now we can provide a definition for the returns to scale of a production function:
a) Constant returns to scale: if we increase all the inputs of production by an
amount r, the total output will increase by the same amount r. In terms of
homogeneity, constant returns to scale are equivalent to say that the
production function is homogeneous of degree 1;
b) Decreasing returns to scale: if we increase all the inputs by r, the total output
increases by an amount less than r;
c) Increasing returns to scale: if we increase all the inputs by r, the total output
increases by an amount larger than r;
Example: the Cobb-Douglas production function
Y = F ( K , L ) = K L

where and are two positive constants.

To check the degree of homogeneity:
F (rK , rL) = (rK ) (rL) = r K r L = (r ) + K L

= r ( + ) F ( K , L )

13

The Cobb-Douglas production function is homogenous of degree + (it is exactly

the k in our previous definition).
Therefore, we have constant returns to scale when + = 1, decreasing returns when
+ < 1 and increasing returns when + > 1.
An important property of homogenous functions is given by the Eulers theorem:
Consider a function of n variables f ( x1 , x2 ,..., xn ) homogenous of degree k, then it is
possible to show that:
kf ( x1 , x 2 ,..., x n ) = x1

f
f
f
+ x2
+ ...+ x n
x1
x2
xn

The Eulers theorem tells us that we can rewrite a homogenous function in terms of its
partial-derivatives.
Why is this important for us?
The partial derivatives of the production function we are considering have a nice
economic interpretation:
F ( K , L )
= Marginal productivity of Capital (MPK)
K

F ( K , L )
= Marginal productivity of Labour (MPL)
L

In competitive markets, from profit maximisation conditions, it is true that:

MPK =

r
W
and MPL =
P
P

where r is the cost of renting capital, W is the nominal wage and P is the aggregate
price level. Therefore, r/P is the REAL cost of capital and W/P is the REAL wage.
Those two conditions simply say that in competitive markets the inputs of production
are paid at their marginal productivity. Now we can see how total income is
distributed among the inputs of production (workers and capitalists). Assume that the
production function defining the total output is homogenous of degree 1 (= constant
returns to scale). By the Eulers theorem we can write the production function as
(remember that here k = 1):
F ( K , L) = K

F
F
+L
= K MPK + L MPL
K
L

Multiply each side of the above equation by the aggregate price level P.
Then P F ( K , L) is the VALUE of total production (the GDP of our economy),
while we must notice that MPK P = r and P MPL = W .
Using those facts we can rewrite the above equation as:

14

PY = K r + L W

3)

Equation 3) says that the total income in the economy is equal to the sum of factors
payments. This result is called the Exhaustion Product Theorem.
Therefore, if there are:
a) Constant returns to scale;
b) Competitive markets;

Total output is divided between the payments to capital and the payments to labour,
depending on their marginal productivities.

15

Mathematical Appendix
1) Discrete percentage changes
Consider a variable Y for which you have values for different period of times (t).
Denote with Yt the value of Y in period t (so Yt+1 denotes the value of Y in period t+1
and so on).
a) The discrete percentage change (or the growth rate) in the value of Y between
period t and period t+1 is given by:

Y Y
g = t +1 t 100 or
Yt

Y
g = t +1 1 100

Yt

The difference Yt +1 Yt is called first-difference, and it is denoted with Y = Yt +1 Yt .

Therefore, the percentage change of Y between period t and period t+1 can be written
as:

Y
100
Yt

If we let the difference between Yt +1 Yt to be really small, that is if we take the

following limit:
Y dY
=
0 Y
Y

lim

where dY is an infinitesimal change in Y, we obtain the expression

dY
that is called
Y

the instantaneous growth rate of Y.

b) For any variables X and Y:

the percentage change in (X Y ) percentage change in X + percentage change

in Y
Proof:
Consider a function f ( X , Y ) = XY
The total differential of that function is defined as:
df ( X , Y ) =

f ( X , Y )
f ( X , Y )
dX +
dY
X
Y

The total differential tells me: what is the change in the function ( df ( X , Y ) ) given
small changes in the variables X and Y ( dX , dY ).
The term

f ( X , Y )
indicates the partial derivative of the function with respect the
X

variable X. Given that our function is f ( X , Y ) = XY , by basic calculus we know that:

16

f ( X , Y )
f ( X , Y )
= Y and
=X
X
Y

Therefore, our total differential can be written as:

df ( X , Y ) = YdX + XdY

Using the fact that f ( X , Y ) = XY , we can rewrite the above expression as:
d ( XY ) = YdX + XdY

Dividing each side of the above expression by (XY) we obtain:

d ( XY ) dX dY
=
+
XY
X
Y

The expression

A1)

d ( XY )
dY
dX
and
is the instantaneous growth rate of (XY), while
X
XY
Y

are the instantaneous growth rates of X and Y respectively.

Expression A1) says that the growth rate of XY is equal to the growth rate of X plus
the growth rate of Y. This is true if the change in variables is small (remember: d
denotes a very small change). However, when we consider discrete changes (when we
use instead of d) expression A1) still hold approximately.
End of the proof.
Example: suppose that the real GDP has increased by 2% from 2005 to 2006. Suppose
that inflation measured by the GDP deflator has increased by 3% in the same period.
What is the growth rate of nominal GDP between 2005 and 2006?
We know that:
Nominal GDP = Real GDP

GDP Deflator

Therefore:
Percentage change in Nominal GDP 2 + 3 5%.
c) For any variables X and Y:

the percentage change in (X /Y ) percentage change in X percentage change in

Y

Example. Suppose that population has increased by 1% between 2005 and 2006,
while real GDP has increased by 2% during the same period. What is the percentage
change of the real GDP per capita?
We know that:
Real GDP per capita = (real GDP)/Population
Therefore:
Percentage change in real GDP per capita 2 1 1%.

17

2) Index Numbers

In statistics index numbers are used to describe the behaviour over time of some
interesting variables. In particular, they are useful when we are interested in the
growth rates of those variables over a certain period of time. They are also useful to
compare series of numbers of different size. We normally use index numbers with a
fixed base. For example, consider the following series for GDP in UK from 1997 to
2002 (values are in million of pounds).
Year

GDP

1997

864710

1998

891684

1999

916639

2000

951256

2001

971565

2002

988338

The Index Number is defined as:

Index Number current period =

Current Period Value

100
Base Period Value

First, we need to decide the base period we want to use. For example, use the first
year of the GDP series as the base year. The index number for the GDP is then given
by:
Year

GDP Index

1997

100

1998

103.11

1999

106

2000

110

2001

112.35

2002

114.29

Some of the calculations are:

GDP index 1997 =

GDP value 1997

864710
100 =
100 = 100
GDP value 1997
864710

18

GDP index 1999 =

GDP value 1999

916639
100 =
100 = 106
GDP value 1997
864710

Notice that the index number is a pure number (it does not depend on any unit of
measure). Furthermore, the index number does not have any meaning by itself. The
fact that the GDP index in 1998 is 103.11 does not mean anything.
What it is meaningful is that now we can easily compare the behaviour of the series
with respect the base year.
Using the GDP index we can say that in 1998 the GDP was 3.11% higher than in
1997. Or we can say that the GDP in 2002 is 14.3% higher than in 1997, and so on.
Notice that the index number series in the previous table does not tell you the year-toyear growth rate of the variable. We can calculate the year-to-year growth in the GDP
using the original series or using the index number series.
For example, from 1999 to 2000, the GDP has increased by:
GDP2000 - GDP1999
951265 916639
100 =
100 = 3.77%
GDP1999
916639
or using the GDP index series
110 106
100 = 3.77%
106

The most important index numbers used in economics are probably the price indexes.
There are two main ways to calculate a price index:
1) Laspeyers Index:
Consider a set I of good and services, that is I={1,2,i,n}
Denote with:
p i , t the price of good i in period t.

q i , t the quantity of good i sold in period t

p i , 0 the price of good i in period 0 (the base year)
q i , 0 the quantity of good i sold in period 0

The Laspeyres index in period t is defined as:

PL ,t =

(p
(p

i ,t

qi , 0 )
q )

100

i ,0 i ,0

The numerator is the cost of the bundle of I goods and services in period 0 evaluated
at prices at t. The denominator is the cost of the bundle in period 0 (the base year).

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Example: suppose you have a basket of goods containing 20 pizzas and 10 compact
discs in year 2002. The prices of a pizza and a compact disc are given by the
following table:
pizza

CDs

2002 $10

$15

2003 $11

$15

2004 $12

$16

2005 $13

$15

We can calculate the Laspeyres index with base year 2002.

In 2002 the index is given by:
PL,2002 =

10 20 + 15 10
100 = 100
10 20 + 15 10

In 2003:
PL,2003 =

11 20 + 15 10
100 = 105.7
10 20 + 15 10

and so on.
The Consumer price index is an example of a Laspeyres index.
The Laspeyers index of our basket of goods is summarised in the following table,
where we reported also the year-to-year inflation.
Year

Index

Inflation rate

2002

100.0

n.a.

2003

105.7

5.7%

2004

114.3

8.1%

2005

117.1

2.5%

2) Paasche Index
Differently from the Laspeyers index, here the basket of goods is changing over time.
The formula is:
PP ,t =

(p
(p

i ,t

q i ,t )
q )

100

i , 0 i ,t

The GDP deflator is an example of a Paasche Index.

Notice that in order to calculate the Paasche index using the previous example we
should know the quantities sold in each year.

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