Question

1. Suppose the data for a hypothetical economy is given above. This economy produces only 3 things, pizzas, haircuts and tanks. The base year is 2019.

	Quantity of pizzas	Quantity of haircuts	Quantity of tanks	Price of pizzas	Price of haircuts	Price of tanks
2019	100	20	10	$10	$15	$150
2020	120	30	12	$10	$16	$120

1. Calculate GDP deflator in 2020. Based on GDP deflator, what is the inflation rate from 2019 to 2020?
2. Suppose a representative consumer basket consists of 10 pizzas and 20 haircuts. Using this consumer basket, calculate CPI in 2020 (again, assuming 2019 is the base year). Based on CPI, what is inflation rate?
3. Why do you think there is such a dramatic difference in the inflation rates from parts a and b?

Answer 1

(a)

(i) Nominal GDP (NGDP) = (Current year price x Current year quantity)

2019 = 10 x 100 + 15 x 20 + 150 x 10 = 1000 + 300 + 1500 = 2800

2020 = 10 x 120 + 16 x 30 + 120 x 12 = 1200 + 480 + 1440 = 3120

(ii) Real GDP (RGDP) = (Base year (2019) price x Current year quantity)

2019 = 10 x 100 + 15 x 20 + 150 x 10 = 1000 + 300 + 1500 = 2800

2020 = 10 x 120 + 15 x 30 + 150 x 12 = 1200 + 450 + 1800 = 3450

(iii) GDP Deflator = (NGDP / RGDP) x 100

2019 = (2800 / 2800) x 100 = 100

2020 = (3120 / 3450) x 100 = 90.43

(iv) Inflation rate = % Change in GDP deflator = (90/43 / 100) - 1 = 0.9043 - 1 = - 0.0957 = - 9.57%

(b)

(i) CPI, year N = (Cost of basket, year N / Cost of basket, base year) x 100

Cost of basket, 2019 = 10 x 10 + 15 x 20 = 100 + 300 = 400

Cost of basket, 2020 = 10 x 10 + 16 x 20 = 100 + 320 = 420

CPI, 2019 = (400/400) x 100 = 100

CPI, 2020 = (420/400) x 100 = 105

(ii) Inflation rate = % Change in CPI = (105/100) - 1 = 1.05 - 1 = 0.05 = 5%

(c)

Since GDP includes all domestically produced goods, tanks are included in computing NGDP and RGDP. But tanks are not used by households, so are excluded from CPI calculation. Therefore, inflation rates are different.