EC 214 - MACROECONOMICS II

SPRING 2018 - 2019

CLASS 2

# Question 1
The following table describes the production of goods and services taking place in Bilgitopia
in 2016 & 2018. Real GDP values are calculated by taking 2016 as the base year. In addition
to the data given below, it is reported that the nominal GDP of Bilgitopia did not grow at all
between 2017 and 2018. Use these pieces of information to calculate the values of variables
marked with question marks.

Good A Good B Good C

Nominal GDP Real GDP
Year Price Quantity Price Quantity Price Quantity
B
2016 10 20 P2016 =? 12 25 4 N GDP2016 =? 480
2017 15 24 6 10 20 QC
2017 =? 500 RGDP2017 =?
A
2018 P2018 =? 20 10 8 20 3 N GDP2018 =? RGDP2018 =?

# Solution of Question 1

Let’s start with the year 2016. Since 2016 is reported to be the base year used during
real GDP calculations, we must have N GDP2016 = RGDP2016 = 480. Using this results, we
B
can also calculate P2016 in the following way:

N GDP2016 = QA A B B C C
2016 × P2016 + Q2016 × P2016 + Q2016 × P2016
B
480 = 20 × 10 + P2016 × 12 + 25 × 4
B
480 = 200 + 12P2016 + 100
B
180 = 12P2016
B
P2016 = 15

We can find QC
2017 using that N GDP2017 = 500 as we know all other components of 2017’s
nominal GDP:

N GDP2017 = QA A B B C C
2017 × P2017 + Q2017 × P2017 + Q2017 × P2017
500 = 24 × 15 + 10 × 6 + QC
2017 × 20
500 = 360 + 60 + 20QC
2017
80 = 20QC
2017
QC
2017 = 4

As we now have all quantities of year 2017 and know all prices from 2016 - which is our
base year - it is perfectly possible for us to calculate 2017’s real GDP:

1
 RGDP2017 = QA A B B C C
2017 × P2016 + Q2017 × P2016 + Q2017 × P2016
= 24 × 10 + 10 × 15 + 4 × 25
= 240 + 150 + 100
= 490

A
In order for us to be able calculate either one of P2018 or N GDP2018 , the other variable’s
value must be known - however our table does not contain information for neither of those
two. But in the main text we are told that the growth rate of nominal GDP between 2017
and 2018 is zero - hence the nominal GDP should not change between these two years.
Growth rate of
Nominal GDP
N GDP2018 − N GDP2017
= × 100
2017-2018 N GDP2017
N GDP2018 − N GDP2017
0= × 100
N GDP2017
N GDP2018 = N GDP2017 = 500
A
Now using this information we can calculate P2018 :

N GDP2018 = QA A B B C C
2018 × P2018 + Q2018 × P2018 + Q2018 × P2018
A
500 = 20 × P2018 + 8 × 10 + 3 × 20
A
500 = 20P2018 + 80 + 60
A
360 = 20P2018
A
P2018 = 18

Finally, as we know the quantities of all goods for 2018 and know the base year prices of
all goods, we can calculate the real GDP of 2018:

RGDP2018 = QA A B B C C
2018 × P2016 + Q2018 × P2016 + Q2018 × P2016
= 20 × 10 + 8 × 15 + 3 × 25
= 200 + 120 + 75
= 395

2
# Question 2
Suppose that we have an economy in which only two goods are produced and consumed every
year, namely good A and good B. The table below gives the quantity and price information
for both goods in years 2016 and 2017:

Good A Good B
Year Price Quantity Price Quantity
2016 20 20 30 20
2017 15 40 10 100

Using the information shown in the table above to answer the following questions:
a) Calculate nominal GDP in 2016 and 2017.
b) Calculate real GDP in 2016 and 2017 by choosing 2016 as your base/reference year.
c) Suppose that you are given the task to monitor average well being of citizens in this
country. Out of nominal and real GDP, which one would you choose to correctly accomplish
this task. Why?
d) Calculate inflation between years 2016-2017 by using consumer price index (CPI) ap-
proach by choosing 2016 as your base/reference year.
e) Calculate inflation between years 2016-2017 by using the GDP deflator approach.
f ) Compare the inflation levels you have found in parts ”d” and ”e”. Does which approach
result in a higher inflation prediction? Why?

# Solution of Question 2
a)

Price of A Quantity of A Price of B Quantity of B

Nominal GDP in 2016 = × + ×
in 2016 in 2016 in 2016 in 2016
= 20 × 20 + 30 × 20
= 400 + 600
= 1000

Price of A Quantity of A Price of B Quantity of B

Nominal GDP in 2017 = × + ×
in 2017 in 2017 in 2017 in 2017
= 15 × 40 + 10 × 100
= 600 + 1000
= 1600

b)

Real GDP in 2016 = Nominal GDP in 2016 = 1000 since base year is 2016

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 Price of A Quantity of A Price of B Quantity of B
Real GDP in 2017 = × + ×
in 2016 in 2017 in 2016 in 2017
= 20 × 40 + 30 × 100
= 800 + 3000
= 3800

c) Real GDP (or per capita real GDP) is a better indicator of living standards since it is
immune to price fluctuations over time and hence only reflects changes in quantity over time.
On the other hand, nominal GDP is also affected from price changes and inflation.
For example, if we focus on nominal GDP in a country where prices of goods and services
increase and production levels are constant over time then we will inadvertently conclude
that living standards are increasing over time. On the other hand, if we calculate the real
GDP of this country, then it will turn out to be constant over time and enable us to correctly
conclude that living standards do not change over time in this country.
d)
cost of the reference year’s consumption
bundle with 2016 prices
CP I2016 = cost of the reference year’s consumption
× 100
bundle with reference year’s prices
cost of the reference year’s consumption
bundle with 2016 prices
= cost of the reference year’s consumption
× 100
bundle with 2016 prices
= 100

cost of the reference year’s consumption

bundle with 2017 prices
CP I2017 = cost of the reference year’s consumption
× 100
bundle with reference year’s prices
cost of the reference year’s consumption
bundle with 2017 prices
= cost of the reference year’s consumption
× 100
bundle with 2016 prices
15 × 20 + 10 × 20
= × 100
20 × 20 + 30 × 20
500
= × 100
1000
= 50

CP I2017 − CP I2016
inflation = × 100
CP I2016
50 − 100
= × 100
100
= −50

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 Instead of inflation, CPI approach tells us that we face deflation and overall price level
declines between 2016 and 2017.

e)

Nominal GDP in 2016

Def lator2016 = × 100
Real GDP in 2016
1000
= × 100
1000
= 100

Nominal GDP in 2017

Def lator2017 = × 100
Real GDP in 2017
1600
= × 100
3800
≈ 42, 1

Def lator2017 − Def lator2016

inflation = × 100
Def lator2016
42.1 − 100
= × 100
100
= −57.9

Similar to the previous part, we also end up with deflation by following the deflator ap-
proach as well.

f ) Since consumer price index utilizes a fixed consumption bundle over time, it suffers from
substitution bias: Normally, out of two similar goods we expect consumers to consume the
one that is relatively cheaper. Hence, if the goods available in an economy are similar to each
other and consumers tend to consume more from the one that is cheaper then consumer price
index will not be able to reflect this consumer behavior and overstate inflation. However, the
deflator is able to reflect this consumer behavior as it does not involve a constant consumption
bundle, and therefore does not suffer from substitution bias. Due to the substitution bias,
consumer price index predicts a higher inflation level compared to deflator (−50 > −57.5).