Question

1.      In country Water, there are only 2 goods: Wave and Fish. The following table shows the prices and quantities produced of these goods in 2005, 2010, and 2015:

	2005		2010		2015
	P	Q	P	Q	P	Q
Wave	40	450	30	400	75	620
Fish	60	550	55	800	105	830

i)      Calculate NGDP, RGDP, GDP Deflator for all the three years.

ii)    Calculate cost of basket, CPI for the same years

iii)  Calculate inflation for year 2015 from 2010 using both GDP deflator and CPI. Does the answer vary between the two methods? Explain why or why not   

2. A) What are the main differences between financial market and financial intermediary? Why would you choose to diversify your bonds and stocks when you have the alternative option of buying stocks/ bonds of a big amount from a single organization?

B) What happens in the labor market when companies follow Minimum Wage Law? Explain with a graph. Remember to explain the supply, demand of available labor in the market and the ongoing minimum wage of the market

Answer 1

Q1)

(i) Nominal GDP = current year output*current year prices

2005 = 40*450 + 60*550 = 51000

2010 = 30*400 + 55*800 = 56000

2015 = 75*620 + 105*830 = 133650

Real GDP = current year output*base year prices (let 2005 be the base year)

2005 = 40*450 + 60*550 = 51000

2010 = 400*40 + 800*60 = 64000

2015 = 620*40 + 830*60 = 74600

GDP deflator = (nominal GDP / Real GDP)*100

2005 = (51000/51000)*100 = 100

2010 = (56000/64000)*100 = 87.5

2015 = (133650/74600)*100 = 179.15

(ii) CPI = (cost f basket in current year / cost in base year)*100

2005 = 100 (since CPI is 100 in base year)

2010 = ((450*30 + 550*55)/51000)*100 = 85.78

2015 = ((450*75 + 550*105)/51000)*100 = 179.41

(iii) inflation according to CPI = (CPI 2015 - CPI 2010 / CPI 2010)*100 = ((179.41-85.78)/85.78)*100 = 109.15%

inflation according to GDP deflator = (GDP deflator 2015 - GDP deflator 2010 / GDP deflator 2010)*100

= ((179.15-87.15)/87.15)*100 = 105.56%

Thus, inflation is higher using CPI. This is beacuse while GDP deflator uses all the goods and sevices in the economy, CPI only includes a select basket of consumption goods to measure inflation. Moreover, CPI does not reflect the substitution bias as people substitute away from products whose price has increased. Thus, inflation through CPI is overestimated.