Question

2. Consider the following data for a hypothetical economy that produces two goods, milk and honey.

	Quantity Produced		Prices
	Milk (litres)	Honey (kg)	Milk ($/litre)	Honey ($/kg)
Year 1	110	45	2	6
Year 2	125	40	3	7

1. Compute nominal GDP for each year in this economy.
2. Using year 1 as the base year, compute real GDP for each year. What is the percentage change in real GDP from year 1 to year 2?
3. Using year 1 as the base year, compute the price deflator for each year.
4. Now compute the GDP deflator for each year, using year 2 as the base year.
5. Explain why the measures of real GDP growth (and growth in the deflator) depend on the choice of base year.

Answer 1

Nominal GDP = Sum of price of current year * quantity of current year

Real GDP = Sum of price of base year * quantity of current year

GDP Deflator = Nominal GDP/Real GDP * 100

Growth in Real GDP = (Real GDP2 - Real GDP1) / Real GDP1 * 100

Now for Y1 (Y1 is base year)

Nominal GDP Y1 = 2*110+6*45=490

Real GDP Y1 = 2*110+6*45 = 490

GDP Deflator Y1 = 490/490 * 100 = 100

Now for Y2 (Y1 is base year)

Nominal GDP Y2 = 3*125+7*40=655

Real GDP Y2 = 2*125+6*40 = 490

GDP Deflator Y2= 655/490 * 100 = 133.67

Real GDP Growth = (490-490)/490 = 0, Hence NO GROWTH

Now considering Y2 as base year

Nominal GDP remains the same but Real GDP will change as the base year has changed

Real GDP Y1 = 3*110+7*45=645

Real GDP Y2 = 3*125+7*40 = 655

Deflator Y! = 490/645 * 100 = 75.98

Deflator Y2 = 655/655 * 100 =100

Real GDP depends upon choice of the base year and as stated above is calculated on the basis of prices of the goods in base year and quantity in current year. If you change base year, prices in calculation of real GDP will change and the value of final Real GDP will change.

As the growth of real GDP and deflator are dependent on Real GDP value therefore any change in base year will change these value too.