Consider a simple economy that produces two goods cupcakes a

Consider a simple economy that produces two goods: cupcakes and oranges. The following table shows the prices and quantities for the goods over a three-year period. Year Cupcakes Oranges Price Quantity Price Quantity (Dollars per cupcake) (Number of cupcakes) (Dollars per orange) (Number of oranges) 2008 2 115 5 175 2009 4 150 2 180 2010 1 100 2 160 Use the information from the previous table to fill in the following table. Year Nominal GDP Real GDP GDP Deflator (Dollars) (Base year 2008, Dollars) 2008 2009 2010 From 2009 to 2010, nominal GDP , and real GDP . The inflation rate in 2010 was . Why is real GDP a more accurate measure of an economy\'s production than nominal GDP? Nominal GDP is adjusted for the effects of inflation or deflation, whereas real GDP is not. Real GDP does not include the value of intermediate goods and services, but nominal GDP does. Real GDP is not influenced by price changes, but nominal GDP is.

Solution

The table could be written as—

Cupcakes

Oranges

Price

Quantity

Price

Quantity

Year

Dollars per Cupcakes

Number of Cupcakes

Dollars per Oranges

Number of Oranges

2008

2

115

5

175

2009

4

150

2

180

2010

1

100

2

160

Now let first define the concepts of Nominal GDP, Real GDP and GDP Deflator in order to under the process and the result completely.

Nominal GDP:

It is defined as the value of output produced for a current period within a domestic boundary for a pre-determined goods basket. It is calculated based on the current period’s price level.

Real GDP:

It is defined as the values of output produced within a domestic boundary for the current period adjusted with the change in price level, or simply inflation or deflation. It is calculated based on the price of the base period.

GDP Deflator:

It is defined as the ratio between the Nominal GDP and the Real GDP, which basically describes the value of the current output at the current prices with respect to the value of the same output at the base prices. So, this actually gives us the change in the value of the output produced in the current period due to the change in the price level. Therefore, this could also be known as price deflator.

In our case, the fixed basket of goods consist Cupcakes and Oranges. And the base year taken for the calculation of real GDP is 2008. The prices of Cupcakes and Oranges at the base year are $2 and $5 respectively.

So, we could find out the above mentioned variables as follows—

Year

Nominal GDP ($)

Real GDP ($)

GDP Deflator

2008

2 * 115 + 5 * 175 = 1105

2 * 115 + 5 * 175 = 1105

1105/1105 = 1

2009

4 * 150 + 2 * 180 = 960

2 * 150 + 5 * 180 = 1200

960/1200 = 0.8

2010

1 * 100 + 2 * 160 = 420

2 * 100 + 5 * 160 = 1000

420/1000 = 0.42

From the above table we could say that, from 2009 to 2010, the Nominal GDP decreases by (960 – 420) = 540 dollars.

And the Real GDP decreases by (1200 – 1000) = 200 dollars for the same period.

Since, the GDP deflator also describes the price deflation, we could say that for the year 2010, the inflation rate was decreased by (0.8 – 0.42) = 0.38 or 38% from the year 2009.

Now, according to the definition of Nominal GDP, it is to be noted that the value of the Nominal GDP rises for either increase in the level of output or the price level.

So, even if the output remains the same, but the price level rises, Nominal GDP would show an upward trend. Since the rise in price level hurts the purchasing power of the consumers and as there is no actual improvement in the level of production that we could see from the upward trend of Nominal GDP, we could say that the Nominal GDP is a crude measure of welfare.

On the other hand, according to the definition of Real GDP, the value of the current period’s output is measured based on the price level of the base period. So, the increase in Real GDP would definitely means an increase in the level of output as the price remains the same. Thus, Real GDP is more genuine measure of welfare of the people of a country.

Since, the Real GDP is not influenced by the price change; it measures the actual well being or the improvement of a country, whereas the change in price level could influence the Nominal GDP to a great extent which could lead us to faulty picture of the economy. This is why Real GDP is more accurate measure of an economy’s production or well being than Nominal GDP.

Hence, option (C) would be the correct answer.

	Cupcakes	Oranges
Price	Quantity	Price	Quantity
Year	Dollars per Cupcakes	Number of Cupcakes	Dollars per Oranges	Number of Oranges
2008	2	115	5	175
2009	4	150	2	180
2010	1	100	2	160