Question

3. Inflation a) What is the difference between real and nominal GDP? _______________________________________________________________ _______________________________________________________________

b) Suppose the base year is 2005, and the only goods in the economy are apples and bananas. In 2005 both apples and bananas cost $1, and 100 apples and 100 bananas are produced. In 2006, apples cost $20 and bananas cost $5, and 50 apples and 200 bananas are produced.

1. What is nominal GDP in 2005? _______ In 2006? _______ 2. What is real GDP in 2005? _______ In 2006? _______

3. What is the GDP deflator in 2005? _______ In 2006? _______

4. Suppose the fixed basket of goods is 1 apple and 2 bananas. 5. What is the level of the CPI in 2005? _______ In 2006? _______ 6. What is the CPI inflation rate from 2005 to 2006? _______

c) What are the three effects that bias the measurement of CPI? i. _____________________ ii. _____________________ iii. _____________________

d) Which of the three effects listed in part c does each of the following illustrate? 1. US households in 2010 spent a larger fraction of their income on televisions than they did in 1950. __________________________ 2. All televisions available in 2010 had higher resolution than any televisions available in 1950. __________________________ 3. In 1950, no US household had a plasma screen television, but in 2010 they are widely available. __________________________

e) Suppose the average television purchased in 1950 cost $200, and the average television purchased today costs $700.

1. What is the percentage change in the average television price? _______

2. Taking into account the effects in part c, is this percentage increase likely an underestimate or overestimate of the true change in the cost of televisions? ____________

3. Why? ____________________________________________________

Answer 1

(3)

(a) Nominal GDP is the market value of all final goods and services produced within the economy in a given period, measured with current year prices. Real GDP is the market value of all final goods and services produced within the economy in a given period, measured with base year prices. Therefore, real GDP is adjusted for inflation and reflects the change in purchasing power in the economy.

(b)

(1) Nominal GDP (NGDP) ($) = (Current year price x Current year quantity)

2005 = 1 x 100 + 1 x 100 = 100 + 100 = 200

2006 = 20 x 50 + 5 x 200 = 1000 + 1000 = 2000

(2) Real GDP (RGDP) ($) = (Base year (2005) price x Current year quantity)

2005 = 1 x 100 + 1 x 100 = 100 + 100 = 200

2006 = 1 x 50 + 1 x 200 = 50 + 200 = 250

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

2005 = (200 / 200) x 100 = 100

2006 = (250 / 200) x 100 = 125

(4) and (5) CPI is computed using a fixed basket of goods and services.

Cost of basket, 2005 = 1 x 1 + 1 x 2 = 1 + 2 = 3

Cost of basket, 2006 = 20 x 1 + 5 x 2 = 20 + 10 = 30

CPI, 2005 = 100 (base year CPI is always 100)

CPI, 2006 = (Cost of basket, 2006 / Cost of basket, 2005) x 100 = (30 / 3) x 100 = 1000

(6) CPI inflation rate = % Change in CPI = (1000 / 100) - 1 = 10 - 1 = 9 = 900%

NOTE: As per Answering Policy, 1st 6 parts are answered.