Get started for free
Log In Start studying!
Get started for free Log out
Chapter 24: Problem 5
A small nation idolizes the TV show The Voice. All they produce and consumeare karaoke machines and CDs, in the following amounts:$$\begin{array}{lccccc} & {\text { Karaoke Machines }} && {\text { CDs }} \\\& \text { Quantity } & \text { Price } & \text { Quantity } & \text { Price }\\\\\hline 2020 & 10 & \$ 40 & 30 & \$ 10 \\\2021 & 12 & 60 & 50 &12\end{array}$$ a. Using a method similar to the CPI, compute the percentage change in theoverall price level. Use 2020 as the base year and fix the basket at 1 karaokemachine and 3 CDs. b. Using a method similar to the GDP deflator, compute the percentage changein the overall price level. Again, use 2020 as the base year. c. Is the inflation rate in 2021 the same using the two methods? Explain whyor why not.
Short Answer
Expert verified
The CPI-based inflation rate is calculated using a fixed basket of goods, while the GDP deflator-based inflation rate considers changes in quantities produced and consumed. Therefore, the inflation rates may differ due to the different approaches each method takes into account.
Step by step solution
01
Calculate the Cost of the Basket in the Base Year
The basket consists of 1 karaoke machine and 3 CDs. In 2020, the price of one karaoke machine is \(40 and the price of one CD is \)10. Calculate the total cost of the basket for the base year (2020) by multiplying the quantity of each item in the basket by its price, and then summing these values.
02
Calculate the Cost of the Basket in the Current Year (2021)
Using the same basket quantities as in the base year (1 karaoke machine and 3 CDs), calculate the cost of the basket in 2021. The price of one karaoke machine in 2021 is \(60 and the price of one CD is \)12. Multiply the quantity of each item by its respective price and sum the values to get the total cost of the basket for 2021.
03
Calculate the CPI-Based Percentage Change in Overall Price Level
To compute the CPI-based percentage change, divide the cost of the basket in the current year (2021) by the cost of the basket in the base year (2020) and multiply by 100. Then subtract 100 to find the percentage change.
04
Calculate Nominal GDP for Each Year
Nominal GDP is calculated by summing the products of the quantities of goods produced and their respective prices for each year. Use the data for all karaoke machines and CDs produced and their prices to calculate the nominal GDP for both 2020 and 2021.
05
Calculate Real GDP for 2021 Using Base Year Prices
Real GDP for the current year (2021) is calculated using the quantities for 2021 and the prices from the base year (2020). This represents the value of goods produced in 2021 valued at 2020 prices.
06
Calculate the GDP Deflator-Based Percentage Change in Overall Price Level
The GDP deflator is calculated by dividing the nominal GDP by the real GDP for the current year (2021) and multiplying by 100. The percentage change in overall price level is then found by comparing the GDP deflator for 2021 to that of the base year (2020).
07
Discuss Inflation Rates and the Difference Between the Two Methods
Explain that the inflation rate is the rate at which the general level of prices for goods and services is rising. In 2021, inflation rates can differ between the CPI method and the GDP deflator method because CPI uses a fixed basket of goods while the GDP deflator reflects the prices of all goods produced domestically.
Key Concepts
These are the key concepts you need to understand to accurately answer the question.
Consumer Price Index (CPI)
Understanding the Consumer Price Index (CPI) is essential for grasping inflation rate calculations. CPI measures the overall change in the cost of a fixed 'basket' of goods and services purchased by a typical consumer from one period to another. In the exercise above, this 'basket' comprises 1 karaoke machine and 3 CDs.
To calculate CPI, we start by determining the total cost of this basket in the base year, which in this case is 2020. The CPI for the base year is typically set to 100. We then calculate the cost of the identical basket in the current year (2021) using that year's prices. To find the CPI for 2021, we divide the total cost of the basket in 2021 by the cost in 2020, and multiply by 100. Finally, to extract the inflation rate, we compare the CPIs across the two periods by subtracting 100 from the CPI of the current year. This gives us the percentage change in the overall price level, reflecting the inflation rate according to the CPI.
GDP deflator
The GDP deflator is another important tool for measuring inflation. Unlike CPI, which uses a fixed basket of goods, the GDP deflator encapsulates the average price change for all domestically produced goods and services in an economy. It's called a 'deflator' because it deflates the nominal GDP —the total value of goods produced at current prices— to yield the real GDP, which reflects the value at constant prices.
To calculate the GDP deflator, we first find the nominal GDP for a given year by summing the products of quantities and prices of all produced goods. We also need to compute the real GDP by using the base year prices. The GDP deflator is the ratio of nominal GDP to real GDP multiplied by 100. By comparing the GDP deflators over two periods, we can determine the inflation rate. This exercise required such a calculation, and as the GDP deflator accounts for changes in all domestic products, it captures a wider range of price changes compared to CPI.
Nominal vs Real GDP
When discussing economic growth, we differentiate between nominal GDP and real GDP. Nominal GDP represents the market value of all final goods and services produced within a country during a specific period, calculated using current year prices. In contrast, real GDP is nominal GDP adjusted for inflation, using base year prices to maintain comparability across different time periods.
In the given exercise, calculating real GDP involves using 2020 prices for 2021's production quantities. This strips out the effect of price changes, providing a clearer picture of economic growth. Comparing nominal and real GDP gives us vital information about an economy — while nominal GDP indicates the current production value, real GDP is a better gauge of actual productivity and economic growth.
Price Level
Price level is another term pivotal in understanding inflation and the value of money. It refers to the average of current prices across the entire spectrum of goods and services produced in the economy. An increase in the price level signifies inflation, which means that a unit of currency effectively buys less than it did in prior periods.
Since the price level is an aggregate measure, it brings into perspective how prices shift in an economy as a whole, rather than just for a particular set of goods or services. This concept underpins both CPI and GDP deflator calculations. In our exercise, both calculations aimed to capture changes in the price level between 2020 and 2021 to determine the inflation rate.
Base Year Analysis
The concept of a base year is essential for comparing economic data over time. A base year is a point of reference year with which prices, indexes, and other economic data are compared. The base year is often set at 100 for indexes such as the CPI, making it easier to observe changes.
In our exercise, the year 2020 is the base year. By setting it as the standard, we can calculate real GDP for 2021 to figure out actual economic growth without the distortion of inflation. Similarly, setting 2020 as the base year allows us to measure how much prices have increased when calculating CPI or the GDP deflator. Through base year analysis, we ensure that our comparisons of economic data over time are meaningful and apples-to-apples.
One App. One Place for Learning.
All the tools & learning materials you need for study success - in one app.
Get started for free
Most popular questions from this chapter
What do you think about this solution?
We value your feedback to improve our textbook solutions.
Study anywhere. Anytime. Across all devices.
Sign-up for free
This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept
Privacy & Cookies Policy
Privacy Overview
This website uses cookies to improve your experience while you navigate through the website. Out of these, the cookies that are categorized as necessary are stored on your browser as they are essential for the working of basic functionalities of the website. We also use third-party cookies that help us analyze and understand how you use this website. These cookies will be stored in your browser only with your consent. You also have the option to opt-out of these cookies. But opting out of some of these cookies may affect your browsing experience.
Always Enabled
Necessary cookies are absolutely essential for the website to function properly. This category only includes cookies that ensures basic functionalities and security features of the website. These cookies do not store any personal information.
Any cookies that may not be particularly necessary for the website to function and is used specifically to collect user personal data via analytics, ads, other embedded contents are termed as non-necessary cookies. It is mandatory to procure user consent prior to running these cookies on your website.