Question

Discuss and give examples of measurement and conceptual problems in using nominal versus real values to measure economic performance and of economic well-being.  What does the Consumer Price Index (CPI) do a good job of measuring, and what is not included?  What does Gross Domestic Product (GDP) do a good job of measuring, and what is not included in the measurement of that economic indicator?  

Answer 1

Nominal Variables: The value of variable in monetary terms. It is arrived at by multiplying quantity of a good with its prices in that year. Example- Nominal GDP- The monetary value of all the goods and services produced within a year. Nominal GDP can change because of changes in price level.

Real Variables: The value of variables in terms of other goods or services. The real value is arrived at by adjusting the nominal value for inflation. Example- Real GDP adjusted for inflation using GDP deflator.

The best indicator to measure economic performance and well-being is real GDP. The quantity of goods produced in the year 2013 times the prices of the goods in 2013 is the nominal GDP while the quantity of goods in the year 2014 times the prices of goods in 2013 (base year) is the value of real GDP.

Consumer Price Index (CPI)- An indicator of inflation, that measures changes in the weighted average of prices of a fixed basket of goods and services purchased by the consumers. In other words, it measures the purchasing power of a consumer's dollar.

CPI = cost of basket in current year/ cost of basket in base year *100

CPI includes every consumer, professionals, businesses, self-employed, poor, daily wage earners and the retired persons as well. It has been classified as CPI urban, CPI rural, CPI industrial workers, CPI agricultural laborers. CPI does not cover people in prison and in mental asylum.

Problems with CPI-

1. Suppose a new good is added or the quality of existing good is improved, then CPI does not factor in that while measuring inflation. This non-inclusion of new good in the fixed basket causes inflation to increases the true cost of living.

2. Suppose the prices of goods in the fixed basket increases and people move away from that good. CPI does not take that into account and again causes inflation to increases the true cost of living.

Gross Domestic Product (GDP)- Real gross domestic product (GDP) is the value of all goods and services produced by an economy in a given year adjusted for inflation, expressed in base-year prices. It is a measure to determine the purchasing power of an economy. It is preferable over nominal GDP because it makes the value of goods and services comparable by removing price effect.

However, real GDP is not the perfect indicator to measure economy's well-being because it does not consider the following-

1. Environment- GDP does not factor in the impact of growing economic activity on the environment. It does value the amount spent on environment protection but not its impact. A positive growth in a country's GDP as long as the economy has not depleted much of its natural resources.

2. Externalities- Economic activity produces externalities as well. These may be positive or negative. These may have bad impacts on human health and may lead to deteriorating quality of life. GDP does not consider this aspect while measuring well-being of an economy.

3. Leisure- GDP does not consider leisure time. With increase in income, some people may value leisure more than the income and may start working less.

4. Activities outside the market- Producing vegetables in one's own kitchen garden or doing own household work is not a part of GDP since these activities are not traded in the market.