Our discussion of price indexes describes the GDP deflator and the consumer price index (CPI). But the Federal Reserve (the Fed, for short), in reporting its forecasts of the economy, focuses on a different measure of prices: the personal consumption expenditures (PCE) price index, which is the measure of consumer prices in the national income and product accounts. The Fed announced in November 2007 that it would forecast inflation and other variables four times each year (instead of twice each year as it had done before). It also said that it would forecast both the overall inflation rate in the PCE price index and the core inflation rate of the same index, which excludes food and energy prices.
In the 1990s, the Fed provided forecasts of the inflation rate based on the CPI. But the Boskin Commission’s finding (see “In Touch with Data and Research: Does CPI Inflation Overstate Increases in the Cost of Living?” p. 47) that the CPI measure of inflation substantially overstates increases in the cost of living caused the Fed to move away from focusing on the CPI and to pay more attention to the PCE price index.18 Because the PCE price index is based on actual household expenditures on various goods and services, it avoids the sub-stitution bias inherent in the CPI.19 In addition, the Fed suggested that the PCE
18See the Federal Reserve Board of Governors, Monetary Policy Report to the Congress, February 2000, p. 4.
19The PCE price measure may still suffer from some of the other problems, such as quality adjustment bias, that plague the CPI.
(continued) MyEconLabReal-time data
50 PArT 1 | Introduction
measure of consumption spending is broader than the CPI, and the PCE mea-sure has the advantage of being revised when better data are available, whereas the CPI is not revised.
Other differences between the CPI and PCE price index include differences in the formulas used to calculate the index, the coverage of different items, and the weights given to different items.20 The CPI is an index with a given base year while the PCE price index is a chain-weighted index, as discussed in ”In Touch with Data and Research: The Computer Revolution and Chain-Weighted GDP,” p. 45. The PCE price index covers more types of goods and services, as the CPI is based on the average spending habits of people who live in urban areas, whereas the PCE price index covers all spending on consumer goods in the economy. The weights on different spending categories differ as well; for example, homeownership costs are about 20% of the CPI but only about 11% of the PCE price index.
The Fed used the rate of change of the PCE price index as its main measure of inflation beginning in 2000, but became somewhat dissatisfied with it because short-term shocks to food or energy prices frequently caused sharp fluctuations in the inflation rate. So, in 2004, the Fed switched its main inflation variable to the PCE price index excluding food and energy prices. We call the inflation rate using this index the core PCE inflation rate and we call the inflation rate that includes food and energy prices the overall PCE inflation rate. In announcing the switch in 2004, the Fed argued that the core PCE inflation rate was a better measure of “un-derlying inflation trends.”21
In November 2007, however, the Fed decided that it should provide forecasts to the public for both the overall PCE inflation rate and the core PCE inflation rate. The rationale was laid out in a speech by Federal Reserve governor Frederic Mishkin, who noted that although monetary policymakers should focus on core inflation for determining monetary policy, there was good reason also to keep an eye on overall inflation.22 After all, that measure more closely matches the goods and services actually bought by households, and if unwatched, it may deviate from core inflation in ways that are detrimental to households.
Figure 2.3 shows how overall PCE inflation differs from core PCE inflation.
The figure shows the inflation rates from January 1960 to June 2012.23 You can see in the figure that overall PCE inflation and core PCE inflation differed from each other substantially in many years. Large increases in the price of oil in the mid 1970s and again in the late 1970s caused the overall PCE inflation rate to be above the core PCE inflation rate during these episodes. However, as the relative price
20For more details, see the article by Todd E. Clark, “A Comparison of the CPI and the PCE Price Index,” Federal Reserve Bank of Kansas City Economic Review (Third Quarter 1999), pp. 15–29.
21See the Federal Reserve Board of Governors, Monetary Policy Report to the Congress, July 2004, p. 3.
22“Headline versus Core Inflation in the Conduct of Monetary Policy,” speech at the conference on Business Cycles, International Transmission, and Macroeconomic Policies, HEC Montreal, October 20, 2007.
23The data plotted in Figure 2.3 are the inflation rates between one month and the same month one year earlier. The inflation rate is calculated by dividing the price index for a particular month by the value twelve months earlier, then subtracting 1 and multiplying by 100 to put the result in percentage points. That is, the inflation rate is pt = c a Pt
Pt - 12b - 1 d * 100 where Pt is the price index in month t.
ChAPTEr 2 | The Measurement and Structure of the National Economy 51
2.5 Interest rates
FIGUrE 2.3
Overall PCE inflation rate and core PCE inflation rate, 1960–2012
The overall PCE inflation rate usually differs from the core PCE inflation rate. However, the overall PCE inflation rate tends to revert to the core PCE inflation rate.
Source: Federal Reserve Bank of St. Louis FRED database at research.stlouisfed.org/fred2/
series/PCEPI and PCEPILFE.
–2 0 2 4 6 8 10 12 14
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Inflation rate (percent per year)
Year CORE PCE INFLATION RATE
OVERALL PCE INFLATION RATE
of oil declined in the 1980s, the overall PCE inflation rate was less than the core PCE inflation rate from 1982 to 1987. After that, the core PCE inflation rate has not varied as much as the overall PCE inflation rate. Generally, the overall PCE infla-tion rate tends to revert to the core PCE inflainfla-tion rate after several years of being above it or below it.
Interest rates are another important—and familiar—type of economic variable.
An interest rate is a rate of return promised by a borrower to a lender. If, for ex-ample, the interest rate on a $100, one-year loan is 8%, the borrower has promised to repay the lender $108 one year from now, or $8 interest plus repayment of the
$100 borrowed.
As we discuss in more detail in Chapter 4, there are many different interest rates in the economy. Interest rates vary according to who is doing the borrow-ing, how long the funds are borrowed for, and other factors (see “In Touch with Data and Research: Interest Rates,” p. 116). There are also many assets in the economy, such as shares of corporate stock, that do not pay a specified interest rate but do pay their holders a return; for shares of stock, the return comes in the form of dividends and capital gains (increases in the stock’s market price).
The existence of so many different assets, each with its own rate of return, has the potential to complicate greatly the study of macroeconomics. Fortunately, however, most interest rates and other rates of return tend to move up and down together. For purposes of macroeconomic analysis we usually speak of “the”
interest rate, as if there were only one. If we say that a certain policy causes “the”
interest rate to rise, for example, we mean that interest rates and rates of return in general are likely to rise.
Define real and nominal interest rates.
MyEconLabReal-time data
52 PArT 1 | Introduction
real Versus Nominal Interest rates. Interest rates and other rates of return share a measurement problem with nominal GDP: An interest rate indicates how quickly the nominal, or dollar, value of an interest-bearing asset increases over time, but it does not reveal how quickly the value of the asset changes in real, or purchasing-power, terms. Consider, for example, a savings account with an interest rate of 4%
per year that has $300 in it at the beginning of the year. At the end of the year the savings account is worth $312, which is a relatively good deal for the depositor if inflation is zero; with no inflation the price level is unchanged over the year, and
$312 buys 4% more goods and services in real terms than the initial $300 did one year earlier. If inflation is 4% per year, however, what cost $300 one year earlier now costs $312, and in real terms the savings account is worth no more today than it was a year ago.
To distinguish changes in the real value of assets from changes in nominal value, economists frequently use the concept of the real interest rate. The real interest rate (or real rate of return) on an asset is the rate at which the real value or purchasing power of the asset increases over time. We refer to conventionally measured interest rates, such as those reported in the media, as nominal interest rates, to distinguish them from real interest rates. The nominal interest rate (or nominal rate of return) is the rate at which the nominal value of an asset increases over time. The symbol for the nominal interest rate is i.
The real interest rate is related to the nominal interest rate and the inflation rate as follows:
real interest rate = nominal interest rate - inflation rate (2.12) = i - p.
We derive and discuss Eq. (2.12) further at the end of the book in Appendix A, Section A.7.24 For now, consider again the savings account paying 4% interest. If the inflation rate is zero, the real interest rate on that savings account is the 4%
nominal interest rate minus the 0% inflation rate, which equals 4%. A 4% real interest rate on the account means that the depositor will be able to buy 4% more goods and services at the end of the year than at the beginning. But if inflation is 4%, the real interest rate on the savings account is the 4% nominal interest rate minus the 4% inflation rate, which equals 0%. In this case, the purchasing power of the account is no greater at the end of the year than at the beginning.
Nominal and real interest rates for the United States for 1960–2011 are shown in Figure 2.4. The real interest rate was unusually low in the mid 1970s; indeed, it was negative, which means that the real values of interest-bearing assets actually were declining over time. Both nominal and real interest rates rose to record highs in the early 1980s before returning to a more normal level in the 1990s. But the real interest rate turned negative in the early 2000s and again beginning in 2010.
The Expected real Interest rate. When you borrow, lend, or make a bank deposit, the nominal interest rate is specified in advance. But what about the real interest rate? For any nominal interest rate, Eq. (2.12) states that the real interest rate depends on the rate of inflation over the period of the loan or deposit—say, one year. However, the rate of inflation during the year generally can’t be deter-mined until the year is over. Thus, at the time that a loan or deposit is made, the real interest rate that will be received is uncertain.
24Equation (2.12) is an approximation rather than an exact relationship. This approximation holds most closely when interest rates and inflation rates are not too high.
ChAPTEr 2 | The Measurement and Structure of the National Economy 53
Because borrowers, lenders, and depositors don’t know what the actual real interest rate will be, they must make their decisions about how much to borrow, lend, or deposit on the basis of the real interest rate they expect to prevail. They know the nominal interest rate in advance, so the real interest rate they expect depends on what they think inflation will be. The expected real interest rate is the nominal interest rate minus the expected rate of inflation, or
r = i - pe, (2.13)
where r is the expected real interest rate and pe is the expected rate of inflation.
Comparing Eqs. (2.13) and (2.12), you can see that if people are correct in their expectations—so that expected inflation and actual inflation turn out to be the same—
the expected real interest rate and the real interest rate actually received will be the same.
The expected real interest rate is the correct interest rate to use for studying most types of economic decisions, such as people’s decisions about how much to borrow or lend. However, a problem in measuring the expected real interest rate is that economists generally don’t know exactly what the public’s expected rate of inflation is. Economists use various means to measure expected inflation. One ap-proach is to survey the public and simply ask what rate of inflation people expect.
A second method is to assume that the public’s expectations of inflation are the same as publicly announced government or private forecasts. A third possibility is to assume that people’s inflation expectations are an extrapolation of recently observed rates of inflation. Unfortunately, none of these methods is perfect, so the measurement of the expected real interest rate always contains some error.
FIGUrE 2.4
Nominal and real interest rates in the United States, 1960–2011
The nominal interest rate shown is the interest rate on three-year Treasury securities. The real inter-est rate is measured as the nominal interest rate minus the average infla-tion rate (using the GDP deflator) over the cur-rent and subsequent two years. The real interest rate was unusually low (actually negative) in the mid 1970s. In the early 1980s, both the nominal and real interest rates were very high. Nominal and real interest rates returned to more normal levels in the 1990s, then fell sharply, with real interest rates becoming negative again in the early 2000s and 2010s.
Source: The implicit price deflator for GDP is the same as for Fig. 2.2. Inflation rates for 2012 and 2013 are assumed to be 2%. The nominal interest rate on three-year Treasury securities is from the Board of Governors of the Federal Reserve System, Statistical
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Interest rate (percent per year)
Year
1. The national income accounts are an accounting framework used in measuring current economic ac-tivity. The national income accounts measure activity in three ways: the product approach, the expenditure approach, and the income approach. Although each gives the same value for current economic activity, all
three approaches are used because each gives a dif-ferent perspective on the economy.
2. Gross domestic product (GDP) is the broadest mea-sure of aggregate economic activity occurring during a specified period of time. The product approach measures GDP by adding the market values of final MyEconLabReal-time data