Question

Question 1: [10 marks] Residents of Fruitopia produce and consume oranges and apples. Prices and quantities of their consumption and production are given in the following table. Use 2018 as base year. You have to use the same data table for all parts of the question.

Year	Price of Oranges	Quantity of Oranges	Price of Apples	Quantity of Apples
2018	$2.40	40	$2.10	70
2019	$2.80	50	$2.20	80

1. [4 marks] Calculate CPI using all the steps for 2018 and for 2019 and rate of inflation for 2019. Show all your work.

2. [4 marks] Using the above table, calculate the nominal GDP, real GDP and GDP deflator for 2018 and for 2019. Calculate the inflation rate for 2019.

3. [2 marks] Give two reasons why CPI and GDP deflator give different rates of inflation.

Answer 1

Question 1)

(a) Nominal GDP formula = current year output*current year prices

FOR 2018: 50*2.5 + 80*2 = 285

FOR 2019: 60*2.8 + 90*2.2 = 366

Real GDP formula = current year output*base year prices (base year is 2018)

FOR 2018: 50*2.5 + 80*2 = 285 (for base year real gdp = nominal gdp)

FOR 2019: 60*2.5 + 90*2 = 330

GDP Deflator formula = (Nominal GDP/Real GDP)*100

FOR 2018 = (285/285)*100 = 100 (for base year GDP deflator is 100)

FOR 2019 = (360/330)*100 = 109.09

Inflation formula = (GDP Deflator for 2019 - GDP Deflator for 2018 / GDP Deflator for 2018)*100 = (109.09-100/ 100)*100 = 9.09%

(b) the Cost of 2018 basket of goods in 2018 prices = 50*2.5 + 80*2 = 285

The Cost of 2018 basket of goods in 2019 prices = 50*2.8 + 80*2.2 = 316

CPI in base year 2018 =100 (base year CPI is always 100)

CPI in 2019 formula = (Cost of 2018 basket of goods in base year prices/ Cost of 2018 basket of goods in 2018 prices)*100

= (316/285)*100

= 110.88

Inflation formula  = (CPI for 2019 - CPI for 2018/ CPI for 2018)*100 = (110.88 - 100/ 100)*100 = 10.88%

(c)

There can be several reasons why inflation from two methods is different.

(1) CPI uses a fixed basket goods and services which are used regularly whereas GDP deflator uses all goods and services in the economy (not applicable here)

(2) CPI will overestimate inflation (as is the case here) beacuse it does not take into accout the substitution bias i.e. people do not consume the same basket of goods every year and substitute between goods.