## Thursday, August 1, 2013

### The whites of their eyes

When there is a comparison of economic quantities, look at the one that comes after the words "relative to" or "per unit of" or "as a share of" or "as a percent of" or like that.

If the one that comes after is "real GDP" or even just "output" then you can with some confidence assume that the resulting values have inflation factored into them. With confidence you can bet that those values follow a path similar to the path of prices. And should those values be compared to the price level, and a causal relation is described, you may brush aside the claims of causality and ask questions to raise doubt about the validity of the evidence offered.

The only exception that comes to mind is if both economic quantities being compared have had the inflation stripped away, as when the growth of real output is considered. A ratio where both numbers are inflation-adjusted does not factor inflation into the result.

The whole purpose of using inflation-adjusted values is to see beyond the distortions that inflation creates. That purpose is defeated when an inflating value is evaluated relative to an inflation-adjusted value.

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## 6 comments:

I like this series you are doing Art cuz I think it starts to get at the problems that arise with the dual nature of the dollar as a medium of exchange and a medium of account. What I mean is this. Incomes are always stated in the number of dollars paid to someone. GDP is reported in the number of dollars paid for something... it is a result of someone transferring their dollars to someone else, an exchange. Inflation measurements try to assess the quality of those dollars. 2008 dollars arent the same as 1988 dollars, but our tools for assessing the quality of the dollars arent really up to the task it seems to me. What ends up happening in a lot of our inflation adjusted metrics appears to me to be akin to comparing someones 1988 weight and 2008 weight and trying to strip out the "pounds".

It is also interesting how the people who do these analyses always arrive at the same solution...... paying workers too much is the source of inflation.

Thanks Greg. I was trying to think of a football game analogy, where for each game the "yard" gets an inch shorter or something. Usually my analogies just turn into mixed metaphors. But maybe I can do it in "weight".

The argument is, Americans are overweight. The US data is US population times weight of the average person. This is divided by rest-of-world population times their average weight in 1988.

And then this evidence is used to say that US overeating is making the world too heavy...

Art wrote:

"The only exception that comes to mind is if both economic quantities being compared have had the inflation stripped away, as when the growth of real output is considered. A ratio where both numbers are inflation-adjusted does not factor inflation into the result."

The above statement is not mathematically correct. For example, the change in real GDP is not the same as the change in GDP.

GDP and GDP deflator are both functions of time. The change in the ratio of the two functions is defined by the quotient rule in calculus:

http://en.wikipedia.org/wiki/Quotient_rule

This graph may help to illustrate how

the quotient rule works with respect to change of real GDP:

http://research.stlouisfed.org/fred2/graph/?g=l9k

Look at the formula for line 1 on the graph

I think he was talking about ratios.

The ratio "real something divided by real somethingelse" is equal to the ratio "nominal something divided by nominal somethingelse".

Whereas, for example, "unit labor cost" is the ratio "nominal wages divided by real gdp". So that is equal to the ratio "real wages divided by real gdp" times the price index. So of course it's proportional to the price index.

Yeah, the exception I had in mind was real gdp for year n+1 divided by real gdp for year n. I hope what I said about that is mathematically correct! But that whole paragraph actually was an afterthought I stuck in there in response to something Greg had said earlier. I guess I changed horses mid-post there. Source of confusion.

But Jim I have to say thank you. I read the Wikipedia article, and looked at the formula for line 1, and the two came together and made sense to me. And the vertical axis info for line one -- with that, I see how the FRED data fits into calculations like the Quotient Rule. I learned something today. Needs more work, but I learned something today. Thanks Jim.

Hi Art,

My comment was only directed at the paragraph about growth of a real variable.

As for the Unit labor cost issue, I tend to agree.

The convention in economics to call an imagined number "real" and the real number "nominal" has always struck me as demonstrating a bias.

jim

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