ECON 20210 - Problem Set 2 Solutions

1. These are the answers:

(a) By definition, over a short interval, the rate of change in nominal GDP is given
by:
d ln Jj=1 qjt pjt J  J
P  X  
d ln Yt 1 X dqjt dpjt qjt pjt dqjt dpjt
= = pjt + qjt = /qjt + /pjt
dt dt Yt j=1 dt dt j=1
Y t dt dt
dq dp
where dtjt /qjt is the rate of change in the quantity of good j, dtjt /pjt is the rate
q p
of change in the price of good j, and jtYt jt is the fraction of aggregate expenditure
directed towards good j.
dq dp
(b) Suppose that dtjt /qjt = 0 for all goods and that dtjt /pjt = 0.01, that is quantities
do not change and all prices increase by 1%. Then d lndtYt = 1%. Clearly, a positive
rate of change in nominal GDP need not reflect an increase in the quantity of
dq
output produced. Viceversa, suppose that dtjt /qjt = 0.01 for all goods and that
dpjt
dt
/pjt = −0.01, that is, quantities increase by 1% and prices decrease by 1%.
Then d lndtYt = 0. Clearly, a zero rate of change in nominal GDP may conceal
an underlying change in the quantity of output produced (an increase in the
example). More generally, the expression found in 1.(a) show that Yt is not an
ideal measure to compare GDP across different time periods if the goal is to
ascertain the growth in the productive capacity of the economy over time and/or
the growth in Americans’ standard of living. The reason is that prices change
over time, so part of the change in Y over time results from changes in prices.
Real changes in GDP are what ultimately matters for consumers.
2. These are the answers:
(a) At t = tb , Yt = yt by construction
j
(b) W.l.o.g., suppose that tb < t. Let γt,tb
≡ Pjtb /Pjt . We can write real GDP at time
t using base year tb in this way:
J
X j
ytb = γt,t q p
b jt jt
j=1
j
So, if γt,t b
= 1 ∀j, Yt = ytb . Otherwise, Yt 6= ytb
(c) By definition, over a short interval, the rate of change in real GDP is as follows:
PJ PJ  dqjtb dpjtb

d ln yt b d ln j=1 qjt pjtb j=1 p jtb dt + q jt dt XJ
qjt pjtb dqjt
= = b
= b
/qjt
dt dt yt j=1
y t dt

This shows that a positive change in real GDP always reflects an actual increase
in the quantity of at least some goods and services and, symmetrically, a negative
change in real GDP always reflects an actual decrease in the quantity of at least
some goods and services. A purely nominal change in GDP leaves real GDP
unchanged.

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3. Here are the answers:
(a) Denote the measures of CPI in year t as contained in the data by CP ItF RED (it is
normalized to 100 in 1983). Denote the measure of the GDP deflator in year t as
contained in the data by GDEFtF RED (it is normalized to 100 in 2009). To obtain
the top right panel we apply the following transformation to normalize CPI to
100 in year 2009:
CP It CP I CP I1983 CP I1983
CP It2009=100 ≡ × 100 = × 100 = CP ItF RED ×
CP I2009 CP I1983 CP I2009 CP I2009
Thus, the top right panel plots the time series of GDEFtF RED and CP It2009=100 . To
obtain the bottom left panel we apply the following transformation to normalize
the CPI to 100 in year 1948:
CP I CP It CP I1983 CP I1983
CP It1948=100 = × 100 = × 100 = CP ItF RED ×
CP I1948 CP I1983 CP I1948 CP I1948
and we apply the following transformation to normalize the GDP deflator to 100
in year 1948:
GDEFt GDEFt GDEF2009 GDEF2009
GDEFt1948=100 = ×100 = ×100 = GDEFtF RED ×
GDEF1948 GDEF2009 GDEF1948 GDEF1948
Thus the bottom left panel plots the time series GDEFt1948=100 and CP It1948=100
CP It1948=100
(b) The cost of living computed using the CPI changed by a factor of 100
= 9.8.
GDEFt1948=100
When computing using the GDP deflator it changed by a factor of 100
=
7.96
(c) Just reproduce the figure
(d) The average annual inflation rate between 1948 and 2014 was 3.56% using the
CPI and 3.22% using the GDP deflator. These differences matter because, for
instance, social security (SS) benefits (i.e. public pensions) are adjusted based
on a measure of inflation in order to preserve their purchasing power, the so
called COLA. If the adjustment is applied using an under-estimate of the inflation
rate, beneficiaries (retirees) experience a drop in their purchasing power. Also,
public pension disbursements in the U.S. are very large: in 2014 almost 60 million
Americans received SS benefits (pensions and assistance income). Thus, even
small differences in the measured inflation rate used for COLA adjustments map
into large changes in the total amount paid out by the federal government.
4. (a)
Y1 = 50 × 11.0 + 60 × 20.0 = 1750
Y2 = 55 × 16.9 + 80 × 28.0 = 3169.5
y1 = Y1 , y2 = 55 × 11.0 + 80 × 20.0 = 2205
2205 − 1750
γy = = 0.26
1750
3169.5
πy = = 1.437
2205

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 (b)
50 × 16.9 + 60 × 28.0 2525
πp = = = 1.443
50 × 11.0 + 60 × 20.0 1750
3169.5
γp = = 2196.5
1.443
(c)
71.1478 − 56.5654
γ̃u = = 0.258
56.5654
Pu,1 = 30.938, Pu,2 = 44.548
Y2 /Pu,2 − Y1 /Pu,1
γu = = 0.258
Y1 /Pu,1
Pu is called the true price index because it calculates how expensive it is to obtain
a unit of utility. There’s no agency calculating this index, because people’s utility
functions are not observable.
(d)
πy < piu = 1.4399 < πp
γp < γu < γy
When prices change, people substitute the goods that became relatively more
expensive with goods that became relatively less expensive. πy and πp ignore
these substitution effects. πy overestimates the cost of living for period 2 and πp
overestimates the cost of living for period 1.

5. (a)
πT,1 = (1.006)(1.006)(1.008)(1.007) − 1 = 2.73%
πI,1 = (1.005)(1.006)(1.008)(1.01) − 1 = 2.93%
πM,1 = (1.002)(1.003)(1.002)(1.001) − 1 = 0.8%
πU S,1 = (1.001)(1.002)(1.003)(0.999) − 1 = 0.5%
πT,2 = (1.007)(1.004)(1.005) − 1 = 1.61%
πI,2 = (1.016)(1.017)(1.024) − 1 = 5.81%
πM,2 = (1.003)(1.002)(1.004) − 1 = 0.9%
πU S,2 = (1.002)(1.001)(1.003) − 1 = 0.6%
(b)

gT,1 = growth in nominal exchange rate−inflation in Thailand+inflation in the US

42.2
= − 1 − 0.0273 + 0.005 = 30.89%
31.7
You can calculate the exchange rates for other countries and the other period in
a similar manner.

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 (c) When their currency appreciates (exchange rate goes down) /depreciates (ex-
change rate goes up), their purchasing power goes up/down.
(d) When a country devalues its currency by 20%, US dollars become 25% more
expensive. Since 30 % of the consumption basket is imports from the US, inflation
will be higher by 0.3 × 25% = 7.5%.

6. (a)
$1, 000, 000, 000(intermediate goods) + $200, 000, 000(value added)
= $1, 200, 000, 000
(b)

$1, 200, 000, 000(internal consumption + exports) − $1, 000, 000, 000(imports)

= $200, 000, 000

(c) 5 times more

7. (a)
F A = 950 − 350 − 150(amortization of debt) = 450
(b)
CA = X − M − 150 ⇒ X − M = −450 + 150 = −300
(c)
GDP = A + (X − M ) = 5300 − 300 = 5000
(d)
SN = CA + I = −450 + 1250 = 800
(e) Assuming there was no transfers from the government to the consumers,

C = A − I − G = 5300 − 1250 − 1150 = 2900