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Economics 102

Homework #2
Due: February 1st at the beginning of class

1. Suppose people only consume 3 different goods. The following table shows the
prices and quantities of each good consumed in 2006, 2007, and 2008.

Year Price of
Fish

Quantity
of Fish

Price of
Pork

Quantity of
Pork

Price of
Beef

Quantity of
Beef

2006 \$7 400 \$8 225 \$10 175
2007 8 550 7 250 12 275
2008 9 900 6 275 15 275

a. Calculate nominal GDP in each of the three years.

Nominal GDP is simply equal to the sum of the current year price * current
year quantity of all the goods.
2006: (7*400) + (8*225) + (10*175) = 2,800 + 1,800 + 1,750 = \$6,350.
2007: (8*550) + (7*250) + (12*275) = 4,400 + 1,750 + 3,300 = \$9,450.
2008: (9*900) + (6*275) + (15*275) = 8,100 + 1,650 + 4,125 = \$13,875.

b. Calculate Real GDP in each of the three years, using 2006 as the base

year.

Real GDP is equal to the sum of the base year price * current year quantity of
all the goods.
2006: (7*400) + (8*225) + (10*175) = 2,800 + 1,800 + 1,750 = \$6,350.
2007: (7*550) + (8*250) + (10*275) = 3,850 + 2,000 + 2,750 = \$8,600.
2008: (7*900) + (8*275) + (10*275) = 6,300 + 2,200 + 2,750 = \$11,250.

c. Calculate the GDP deflator for each of the three years.

The GDP deflator is equal to (Nominal GDP / Real GDP)*100.
2006: 100. Because 2006 is the base year we know the deflator has to equal
100 even without doing any calculations.
2007: (9,450 / 8,600)*100 = 109.9.
2008: (13,875 / 11,250)*100 = 123.3.

d. Calculate inflation for 2007 and 2008.

Inflation is equal to the growth rate of the GDP deflator. The growth rate
formula is: ((Year2 – Year1)/Year1) *100.
2007: ((109.9 – 100)/100)*100 = 9.9%.

2008: ((123.3 – 109.9)/109.9)*100 = 12.2%.

e. Calculate Real GDP for 2007 and 2008 using the chain-weighted method.

Using 2006 as the base year, we know that Real GDP is equal to nominal
GDP. Thus Real GDP in 2006 is \$6,350. This gives us the starting point for
the chain-weighted method of calculating real GDP.

To calculate chain-weighted Real GDP for 2007 we need the following four
pieces of information:

2006 quantities at 2006 prices: See part a, \$6,350.
2007 quantities at 2006 prices: See part b, \$8,600.

2006 quantities at 2007 prices: (8*400) + (7*225) + (12*175) = \$6,875.
2007 quantities at 2007 prices: See part a, \$9,450.

Now we calculate the growth rate of GDP with 2006 prices:
((8,600 – 6,350)/6,350)*100 = 35.4%,
Then the growth rate of GDP using 2007 prices:
((9,450 – 6,875)/6,875)*100 = 37.5%.

The next step is to average the two growth rates: (35.4 + 37.5)/2 = 36.45%.

This gives us the chain weighted growth rate of real GDP for 2007. So to
calculate 2007 Real GDP we multiply 2006 real GDP by this growth rate:
(6,350 + (6,350*36.45%)) = \$8,664.6.

Repeating the same process for 2008 gives us the following:

2007 quantities at 2007 prices: See part a, \$9,450.
2008 quantities at 2007 prices: (8*900) + (7*275) + (12*275) = \$12,425.

2007 quantities at 2008 prices: (9*550) + (6*250) + (15*275) = \$10,575.
2008 quantities at 2008 prices: See part a, \$13,875.

Growth rate with 2007 prices: ((12,425 – 9,450)/9,450)*100 = 31.5%
Growth rate with 2008 prices: ((13,875 – 10,575)/10,575)*100 = 31.2%

Average growth rate: (31.5% + 31.2%)/2 = 31.35%.

We use the chain-weighted 2007 GDP as our starting point, and get:
(8,664.6 + (8,664.6*31.35%) = \$11,381.0.

f. Calculate the GDP deflator and inflation using Real GDP from part e.

The GDP deflator is still (Nominal GDP/Real GDP)*100 but now we are
using the chain-weighted measure of Real GDP.

GDP deflator
2006: 100. 2006 is still the base year, so the GDP deflator is still 100.
2007: (9,450/8,664.6)*100 = 109.1.
2008: (13,875/11,381.0)*100 = 121.9.

Inflation
2007: ((109.1 – 100)/100)*100 = 9.1%.
2008: ((121.9 – 109.1)/109.1)*100 = 11.7%.

g. Are your answers to part d and part f the same? Why or why not?

Your answers are not the same. They are close, but there are significant
differences. The first thing that we note is that the chain-weighted method
gives us a lower measure of inflation. In 2007, the chain-weighted method
measures inflation almost 1% lower than the standard method, while at the
same time measuring Real GDP as a higher number. So under the chain-
weighted method, real GDP growth is higher, and inflation is lower.

This is not always the case. The example in your book shows a case where
using the chain-weighting method lowers GDP and raises inflation. The
difference between the two methods is that the original method only uses base
year prices. This means that your choice of base year actually matters. In the
chain-weighted method, because you are using two years worth of prices to
calculate growth rates, the base year does not affect the measurement of
inflation. To check this, calculate inflation in 2008 using 2007 as the base
year using both methods. I will put the results below, but you should verify
my calculations.

This table measures inflation for 2008 using the two different methods of
calculating real GDP.
2006 Base Year 2007 Base Year
Standard method: 12.2% 11.7%
Chaining method: 11.7% 11.7%

h. Using the quantities from 2006 for your market basket, and 2006 as your

base year, calculate the CPI for 2006, 2007 and 2008.

To calculate CPI, First: Fix the market basket. This means that the quantities
you choose should not change for this part. For part a the fixed basket is: 400
fish, 225 pork and 175 beef. Step two is to find prices. The prices are given
in the problem, and the prices will change. Step three is to compute the cost

2006: (\$7*400) + (\$8*225) + (\$10*175) = 2800 + 1800 + 1750 = 6350.
2007: (\$8*400) + (\$7*225) + (\$12*175) = 3200 + 1575 + 2100 = 6875.
2008: (\$9*400) + (\$6*225) + (\$15*175) = 3600 + 1350 + 2625 = 7575.
(Note: When calculating market basket cost for CPI only the prices change.)

Once we have the cost of the market basket, step four is to calculate CPI.
The formula for CPI is: (Current year cost / Base year cost)*100
2006 CPI: (6350/6350)*100 = 100.
2007 CPI: (6875/6350)*100 = 108.3.
2008 CPI: (7575/6350)*100 = 119.3.

i. Using the CPI calculate inflation.

The way that CPI is determined makes the inflation rate simply the growth
rate of CPI. The growth rate formula is: ((Year2 – Year1)/Year1) *100.
2007 Inflation: ((108.3-100)/100)*100 = 8.3%.
2008 Inflation: ((119.3-108.3)/108.3)*100 = 10.1%.

j. Recalculate CPI and inflation using the 2006 quantities for your market

When you change the base year, there is no need to recalculate the market
basket cost, because the basket has not changed. You simply need to
recalculate CPI.
2006 CPI: (6350/7575)*100 = 83.8.
2007 CPI: (6875/7575)*100 = 90.8.
2008 CPI: (7575/7575)*100 = 100.

Then recalculate inflation:
2007 Inflation: ((90.8-83.8)/83.8)*100 = 8.3%.
2008 Inflation: ((100-90.8)/90.8)*100 = 10.1%.
(Note: These inflation numbers are exactly the same as the ones in part i.)

k. Now calculate CPI and inflation using 2008 quantities as your market

In this part the market basket has changed, so we need to recalculate the cost.
Remember when calculating the market basket cost, the quantities remain
fixed.
2006: (\$7*900) + (\$8*275) + (\$10*275) = 6300 + 2200 + 2750 = 11250.
2007: (\$8*900) + (\$7*275) + (\$12*275) = 7200 + 1925 + 3300 = 12425.
2008: (\$9*900) + (\$6*275) + (\$15*275) = 8100 + 1650 + 4125 = 13875.

The CPI calculation does not change:

2006 CPI: (11250/11250)*100 = 100.
2007 CPI: (12425/11250)*100 = 110.4.
2008 CPI: (13875/11250)*100 = 123.3.

Recalculate inflation:
2007 Inflation: ((110.4-100)/100)*100 = 10.4%.
2008 Inflation: ((123.3-110.4)/110.4)*100 = 11.7%.
(Note: These numbers are very different than parts i and j, the difference is
significant and not due to rounding error.)

l. Does which year you choose as a base year matter? How about your

choice of quantities for the market basket?

As you can see from the inflation numbers in parts i and j, the choice of a base
year does not affect inflation at all. As a matter of fact the choice of a base
year is completely arbitrary. However, changing the composition of the
market basket is important. Notice that not all of the prices in this problem
increased by the same amount over time. The price of fish increased by
28.6% (((9-7)/7)*100), while the price of pork decreased by 25% (((6-
8)/8)*100) and the price of beef increased by 50% (((15-10)/10)*100).
Inflation would be different if the market basket contained only beef, then if
the market basket contained only fish. So the choice of a market basket is
very important in calculating inflation.

are the same, why are they the same? If they are different, why are they
different?

The rate of inflation is different depending on the method that you use to
calculate it. Note however that the numbers are similar. With the GDP
deflator we are keeping prices fixed and changing quantities, with CPI we are
keeping quantities fixed and changing prices.

2. Explain under what circumstances you would prefer to use the CPI measure of

inflation and under what circumstances you would prefer the GDP deflator.
Include a discussion of the pros and cons of both methods.

Since the CPI only measures consumer goods, it is only useful for consumer
applications. Wages should be indexed by CPI because what we care about is
allowing people to purchase the same basket of goods, likewise for any cost of living
adjustment (COLA). One example of a COLA is with Social Security. The COLA
was instituted to keep benefits at a constant level of purchasing power over time.
Also anytime you wanted to measure the effect of imports, you need to use the CPI
because the GDP deflator does not include imports in its calculation.

The GDP deflator would be more useful for manufacturing applications. The GDP
deflator takes all aspects of the domestic economy into account, including the effects
of plants, equipment and inventories. The CPI only measures consumer goods. Also
if we are interested in comparing across countries, it may be more useful to use the
GDP deflator.