Question

QUESTION 1 (1,500 pts)

Consider an economy that produces and consumes breads and automobiles. In the following table are data for two different years.

Good	2000		2010
	Quantity	Price	Quantity	Price
Automobiles	100	$50,000	120	$60,000
Breads	500,000	$10	400,000	$20

1. Using 2000 as the base year, compute the following statistics for each year: Nominal GDP, real GDP, the implicit price deflator for GDP, and a fixed-weight price index such as the CPI. (Present your results neatly and concisely in a table. You do not need to show your workings)

2. How much did prices rise between 2000 and 2010? Compare the answers given by the Laspeyres and Paasche price indices. Explain the difference.

3. Suppose you are a senator writing a bill to index Social Security and federal pensions. That is, your bill will adjust these benefits to offset changes in the cost of living. Will you use the GDP deflator or the CPI? Why?

Answer 1

(a)

(b)

The implicit price deflator (i.e. GDP Deflator) will be Paasche index number as

Paasche Price Index = Sum (Observe Price * Observe Qty) / (Base Price * Observation qty) and also it is computed with a changing basket of goods;

The Consumer Price Index (CPI) will be Laspeyres index because

Laspeyres Index Formula= ∑ (Observation Price * Base Qty) / ∑ ( Base Price * Base Qty) and also it is computed with a fixed basket of goods.

The implicit price deflator (GDP Deflator) for the year 2010 is 1.52, which indicates that price rise by 52 percent as compare to year 2000. The CPI for the year 2010 is 1.6, which indicates that price rise by 60 percent as compare to the year 2000. The price of automobiles rise by 20 percent; the price of bread rise by 100 percent, making bread as compare to automobiles more expensive. The CPI weights the price of goods by the quantities purchased in the year 2000. The implicit price deflator weights the price of goods by the quantities purchased in the year 2010. The quantity of bread consumed was higher in 2000 than in 2010, so the CPI places a higher weight on bread. Since the price of bread increased as compare to the price of automobiles, the CPI shows a larger increase in the price level.

(c)

There is no crystal clear answer as measure of the price level precisely captures the cost of living. As we computed above consumers bought less bread and more automobiles. An index with fixed weights, such as the CPI, overestimates the change in the cost of living, on the other hand, an index with changing weights, such as the implicit price deflator i.e. GDP deflator, underestimates the change in the cost of living. Concludingly, CPI will be more beneficial as it maximize benefits by more than the GDP deflator, suggesting that items of bread have seen higher price increases than the automobiles.