Question

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	2012 Quantity	2012 Price (Base year)	2013 Quantity	2013 Price
Food	10	3	12	4
Clothes	7	6	8	8
Entertainment	4	5	6	6

1. (a) The outputs and prices of goods and services in Country X are shown in the table above. Assuming that 2012 is the base year, calculate each of the following.

(i) The nominal gross domestic product (GDP) in 2013

(ii) The real GDP in 2013

(b) If in one year the price index is 40 and in the next year the price index is 50, what is the rate of inflation from one year to the next?

(c) Assume that next year’s wage rate will be 3.5% percent higher than this year’s because of inflationary expectations. The actual inflation rate is 3 percent. At the beginning of next year, will the real wage be higher, lower, or the same as today?

(d) Assume that Zac gets a fixed-rate loan from a bank when the expected inflation rate is 4 percent. If the actual inflation rate turns out to be 2 percent, who benefits from this: Zac, the bank, neither, or both? Explain.

Answer 1

The table is as given below.

	2012 Quantity	2012 Price (Base Year)	2013 Quantity	2013 Price
Food	10	3	12	4
Clothes	7	6	8	8
Entertainment	4	5	6	6

1. (a) (i) The nominal GDP in a particular year , where i's are different products, y refers to that year, and P, Q are price and quantity. Nominal GDP in a year considers prices of products in that year. So, Nominal GDP in 2013 is

(ii) The real GDP in a year considers quantity produced in the year and prices of base year, ie Real GDP , where y is current year, while b is base year. So, multiplying and adding the base year price column and quantity 2013 column, we will have the real GDP in year 2013. The Real GDP .

(b) Price Index (PI) in a year is basically reflects the price of a basket of goods which are considered quite necessary for the people. If in a year PI is 40, while in the next year, PI is 50, the inflation is , ie 25%. In other words, the basket of goods which costs less in previous year, and are more costly in next year, have risen in price by 25%.

(c) Assuming that next year’s wage rate will be 3.5%, the actual inflation rate is 3%, at the beginning of the year, the real wage will be HIGHER. It can be seen as the example, or simplification as following. Suppose the Wages were $100 and price of all goods in 1 unit were $100, a worker would consume (assuming he buys all the goods in 1 units) 1 unit of all goods, since wage by price is 1. But, in the next year, their wages become $103.5 (3.5% increment) and the price of all goods in 1 unit becomes $103 (3% increment, as the actual inflation), they can purchase all goods in 1 unit in $103, and still would be left with $0.5 to by a bit more of anything. Hence, their real wages are now HIGHER.

(d) By the same example as above, suppose the bank charges interest rate of 0% pa plus expected inflation, and ZAC gets fixed rate loan of $100 from a bank with expected inflation 4%. This means, Zac has to pay in next year an amount of $100 at 4% interest pa (0% real interest plus 4% inflation equals 4% nominal interest rate), or $104 (since time period is 1year). Zac buys stuffs of 1 unit with that $100, and expects that it would cost $104 in the next year, since expected inflation is 4%. But, the actual inflation in the next year is 2%, not 4%. So, the $100 purchased unit in the previous year now costs $102. But Zac has to pay $104 to the bank due to the agreement. Hence, Zac is at a loss of $2, and hence bank is in profit of $2. If the actual inflation was indeed equal to 4%, Zac would be at neither profit nor loss, and so would be bank. But less than expected inflation resulted to benefit of the bank, as their any normal asset of $100 would amount to $102, but they are getting $104 by giving the $100 as loan to Zac.

Hence, benefit form this would be the Banks.