ECON7074 Chap.3 Real GDP, Price Indexes and Unemployment
Real GDP, Price Indexes and Unemployment
Once output is measured, the next task is to separate quantity from price and to measure joblessness. This chapter starts with nominal and real GDP and shows that real growth depends on which prices are held fixed. A bread and haircut economy is valued at starting and later prices, and you learn to predict which measure runs higher from the way relative prices moved before checking with the chained Fisher index.
New goods show why agencies chain, and the GDP deflator follows as the ratio of nominal to real GDP. The consumer price index is then built in three stages and checked for the four classic upward biases, with their consequences for indexed contracts, government outlays and real wages. Core inflation and the trimmed mean show how reweighting reveals the trend.
The chapter ends with the labour force, the unemployment and participation rates, and an economy where employment grows yet the unemployment rate rises.
What this chapter covers
- 01
Nominal versus real GDP and growth rates
- 02
Laspeyres, Paasche and Fisher chain indexes
- 03
The GDP deflator as a price measure
- 04
Building the CPI and its four biases
- 05
Core inflation, the trimmed mean and substitution bias
- 06
Unemployment, participation and discouraged workers
Worked example · free
Laspeyres and Paasche growth for bread and haircuts
- +1Haircut prices rose 20% while bread prices stayed flat, and bread output grew faster, so year-1 prices weight the slow-growing good more: predict Laspeyres above Paasche.
- +1Nominal GDP is 4,000 + 6,000 = 10,000 in year 0 and 4,400 + 7,380 = 11,780 in year 1.
- +1At year-0 prices, year-1 output is worth 4,400 + 6,150 = 10,550, so Laspeyres growth is 5.5%.
- +1At year-1 prices, year-0 output is worth 4,000 + 7,200 = 11,200, so Paasche growth is 11,780 / 11,200 minus 1, about 5.2%.
- +1The Fisher factor is the square root of 1.0550 times 1.0518, about 1.0534, so chained growth is roughly 5.3% and the prediction holds.
Key terms
- Real GDP
- Output valued at a fixed set of prices, so that changes over time reflect quantities produced rather than price movements.
- Chain-weighted index
- Measure of real growth that compares each pair of adjacent years and links the results, updating the price weights every period.
- Core inflation
- Underlying rate of consumer price growth calculated after excluding volatile food and fuel prices.
- Participation rate
- Share of the working-age population that is in the labour force, either employed or actively looking for work.
- Discouraged worker
- Someone without a job who has stopped searching and is therefore counted outside the labour force, not as unemployed.
Real GDP, Price Indexes and Unemployment FAQ
Why can real GDP growth differ depending on the base year?
Real GDP values quantities at fixed prices, and goods whose output grows fastest often become cheaper. Early-year prices give those goods a heavy weight and late-year prices a light one, so measured growth changes with the base. Chain weighting compares neighbouring years and averages the two answers, which keeps the result stable over long periods.
What is the difference between the GDP deflator and the CPI?
The deflator is the average price of all final output produced in the economy, found by dividing nominal GDP by real GDP. The CPI is the average price of what households consume, priced from a fixed basket, so it is the standard cost-of-living measure. Most of the time the two indexes move together, but they answer different questions about prices.
Why does the CPI tend to overstate inflation?
Its fixed basket misses four adjustments households make or benefit from: new products replacing dearer ones, quality improvements built into price rises, switching away from goods that became relatively expensive, and shopping at cheaper outlets. Each pushes measured inflation above the true change in living costs, which matters for indexed pensions, wages and government spending.
How is the unemployment rate calculated?
Divide the number of unemployed people by the labour force, where the labour force is the employed plus the unemployed. Only people actively searching for work count as unemployed. A frequent error is to divide by the whole working-age population instead, which understates the rate because that denominator wrongly includes people outside the labour force.
Why would the Reserve Bank prefer the trimmed mean to headline CPI?
Headline CPI can jump because of a few items with extreme price changes, such as fuel. The trimmed mean drops the biggest rises and falls and averages the middle 70 per cent of the weighted distribution, giving a steadier reading of persistent inflation pressure. The trade-off is that it hides some large price changes that households do feel.
Exam move
Practise index numbers with tiny two-good economies you invent yourself. For each one, compute nominal GDP, real growth at both price bases and the Fisher chain, then the deflator, and explain in one sentence why the bases disagree. Next, build a three-item CPI with expenditure weights and change one weight to see how a different household's inflation differs.
Learn the four CPI biases by giving each a concrete example from your own spending. For labour measures, draw the population tree from working age down to employed and unemployed, compute both rates, then move a group into discouragement and recompute. Always state which denominator each rate uses. Finish by explaining each result aloud in two sentences without notes.
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