Consider an economy that produces only three types of goods

Consider an economy that produces only three types of goods: computers, oranges, and opera tickets. Below are the data on production and prices for 2014 (the base year) and 2015: Find the GDP deflator for 2015. By what percentage does the price level change from the base year to 2015 Assuming that the consumption basket used to calculate the CPI consists of 3 computers, 200 oranges, and 1,000 opera tickets, use the CPI to calculate the rate of inflation between 2014 and 2015. Explain why your answers to (d) and (e) differ. Now suppose that the computer units in the table are not comparable between 2014 and 2015 because the quality of computers rises over time. In particular, suppose computers can be thought of in just one dimension - computation speed - and that the average computer speed increased by 20% between 2014 and 2015. Moreover, suppose that oranges are of the same quality in the two years but that opera performances became worse (because a larger fraction of talented musicians were drawn into the remixing business, which did not contribute to GDP) by on average 10%. Try to incorporate this information in an updated measure of real GDP growth and the CPI growth between 2014 and 2015. Social Security benefits are increased each year in proportion to the increase in the CPI, even though most economists believe that the CPI overstates actual inflation. Given the quality changes just discussed, from the perspective of the elderly, do you think a quality-adjusted CPI will be desirable or not

Solution

Note:

1. Nominal GDP = Sum of (current year price x current year quantity)

2. Real GDP = Sum of (base year price x current year quantity)

3. GDP Deflator = Nominal GDP / Real GDP

4. Inflation based on GDP deflator = % change in GDP deflator

5. CPI = Sum of (current year price x Base year quantity)

6. CPI based inflation = % change in CPI

7. P0, Q0: Base year (2014) price & quantity

P1, Q1: Current year (2015) price & quantity

(d)

Inflation based on GDP deflator is - 0.6%.

(e)

Inflation based on CPI is - 0.4%.

(f)

The difference arises from the fact that, while GDP deflator depends on real GDP which keeps base year price unchanged, CPI keeps base year quantity unchanged.

NOTE: First 3 sub-parts are answered.

	P0	Q0	P1	Q1	P0 x Q0	P0 x Q1	P1 x Q1	P1 x Q0
Computers	500	3	400	4	1,500	2,000	1,600	1,200
Oranges	0.5	200	0.5	200	100	100.00	100	100
Opera	70	1,000	70	900	70,000	63,000	63,000	70,000
TOTAL					(A)	(B)	(C)	(D)
					71,600	65,100	64,700	71,300
	2014	2015
Nominal GDP (A), (C)	71,600	64,700
Real GDP (A), (B)	71,600	65,100
GDP Deflator	1.0000	0.9939
Change in GDP Deflator		-0.6%
CPI (A), (D)	71,600	71,300
Change in CPI (%)		-0.4%