Economics 104 Principles of Macroeconomics 2017 Spring

Practice 1

1.
What is economic growth? What are the factors that cause economic growth?

Economic growth is an increase in the amount of goods and services produced per head of the
population over a period of time.
The follow causes of economic growth are key components in an economy.
Improving or increasing their quantity can lead to a growth in the economy.
NATURAL RESOURCES
The discovery of more natural resources like oil or mineral deposits may boost Economic growth
as this increases the countrys Production Possibility Curve. It is difficult, if not impossible, to
increase the amount of natural resources in a country. Countries must take care to balance the
supply and demand of scarce natural resources to avoid depleting them. Improved land
management may improve the quality of land and contribute to economic growth.
PHYSICAL CAPITAL
An increased investment in physical capital such as factories, machinery and roads will lower the
cost of economic activity. Better factories and machinery are more productive than physical labor.
This can increase output.
POPULATION
A growth in the labor force means there is a larger population and more manpower. However, this
could lead to high unemployment.
HUMAN CAPITAL
An increase in investment in human capital can improve the quality of the labor force. A skilled
labor force has a significant effect on growth.
TECHNOLOGY
Another influential factor is the improvement of technology. This could increase productivity with
the same levels of labor, thus accelerating growth and development.
LAW
An institutional framework which regulates economic activity such as rules and laws. There is no
specific set of institutions that promote growth.
TRADE
Gains from trade due to specialization according to comparative advantage and exploiting the
economies of scale in production increase economic growth. Countries with more opened economy
typically grow faster than countries with more closed economy.
2.
What is gross domestic product? Explain the three ways to measure gross domestic product.

Gross domestic product (GDP) is the total value of output in an economy and is used to measure
change in economic activity. GDP includes the output of foreign owned businesses that are located
in a country following foreign direct investment. For example, the output produced at the Nissan
car plant on Tyne and Wear and by foreign owned restaurants and banks all contribute to the UKs
GDP.
There are 3 ways of calculating GDP all of which should sum to the same amount. One is the
output approach, one is the expenditure approach and one is the value added approach.

The expenditure approach:

The full equation for GDP using this approach is GDP = C + I + G + (X-M) where
C: Household spending
I: Capital Investment spending
G: Government spending
X: Exports of Goods and Services
M: Imports of Goods and Services

The Income Method: adding factor incomes

Here GDP is the sum of the incomes earned through the production of goods and services. This is:
Income from people in jobs and in self-employment + Profits of private sector businesses +
Rent income from the ownership of land = Gross Domestic product (by factor incomes)
Only those incomes that come from the production of goods and services are included in the
calculation of GDP by the income approach. We exclude transfer payments e.g. the state pension;
income support for families on low incomes; the Jobseekers Allowance for the unemployed and
welfare assistance, such housing benefit; private transfers of money from one individual to
another; income not registered with the Inland Revenue or Customs and Excise. Every year,
billions of pounds worth of activity is not declared to the tax authorities. (This is known as the
shadow economy or black economy.)
The Value Added and Contributions to a Nations GDP method
There are four main wealth-generating sectors of the economy: manufacturing, oil and gas,
farming, forestry and fishing and a wide range of service-sector industries. This measure of GDP
adds together the value of output produced by each of the productive sectors in the economy using
the concept of value added. Value added is the increase in the value of goods or services as a result
of the production process

Value added = value of production - value of intermediate goods

Let us say that you buy a ham and mushroom pizza from Dominos at a price of 14.99 - this is the
final retail price and will count as consumption. The pizza has many ingredients at different stages
of the supply chain, for example tomato growers, dough, mushroom farmers plus the value created
by Dominos themselves as they put the pizza together and get it to the consumer.
Some products have a low value-added, for example those really cheap tee-shirts that you might
find in a supermarket for little more than 5. These are low cost, high volume, low priced products.
Other goods and services are such that lots of value can be added as we move from sourcing the
raw.
3a.
Fill in the blanks in the following table:

Nominal Income Real Income CPI (x100)

1998 275 250 a.____

1999 b.____ 300 130

2000 500 c. ____ 125

Answers:
a. (275/250) x 100 = 110

b. 300 (130/100) = 390

c. 500/(125/100) = 400

3b.
The table below gives the CPI and the price of gasoline per gallon in the fictitious country "Alpha"
between 1995 and 2000. For each year find the CPI inflation rate and the change in the relative
price of gasoline, both from the previous year. Were the changes in the price of gasoline over this
period more likely due to inflation or to changes in the gasoline market?

Price of Gasoline
Per gallon CPI

1995 0.92 .96

1996 1.00 .98
1997 1.25 1.00
1998 1.60 1.03
1999 1.80 1.04
2000 1.95 1.06

Answers:
The relative price of gasoline is increasing indicating the increases in the nominal price of gasoline
are due primarily to changes in the market for gasoline rather than an overall increase in the general
price level.

Inflation rate % increase in the price Relative price of gasoline

of gasoline

1996 2.1% 8.7% 6.6% increase

1997 2.0% 25% 23% increase
1998 3.0% 28% 25% increase
1999 1.0% 12.5% 11.5% increase
2000 1.9% 8.3% 6.4% increase
4.
Here is some data for the economy of the fictitious country "Alpha." Calculate Alpha's GDP.
Explain why each item was or was not included in GDP.

a. Consumption expenditures 1000

b. Exports 125
c. Government purchases of goods and services 300
d. Construction of new homes and apartments 125
e. Sales of existing homes and apartments 320
f. Imports 90
g. Beginning-of-year inventory stocks 140
h. End of year inventory stocks 160
i. Business fixed investments 250
j. Government payments to retirees 160
k. Household purchases of durable goods 265

Answers:
GDP = C + I + G + NX
C=consumption
I=Investment
G=Government spending
NX=net export

a. included as part of C
b. included as part of NX
c. included as part of G
d. included as part of I
e. not included - not produced during the period
f. included as part of NX
g. included as part of calculating I
h. included as part of calculating I
i. included as part of I
j. not included - not a payment for a good or service
k. included as part of C
GDP = (1000 + 265) + (250 + [160 - 140] + 125) + (300) + (125 - 90)

= 1265 + 395 + 300 + 35

= 1995
5.
The table below shows production and prices for a stylized economy. Assume the base year is
2005.

Year Production of X Price per unit of X($) Production of Y Price per unit
of Y ($)
2005 200 units 10 500 5

2010 300 units 15 400 4

2015 400 units 20 200 2

a
Calculate nominal and real GDP for 2005, 2010 and 2015 assuming the base year is 2005.

2005 (base year):

Nominal GDP = (200 $10) + (500 $5) = $4500
Real GDP = (200 $10) + (500 $5) = $4500

2010:
Nominal GDP = (300 $15) + (400 $4) = $6100
Real GDP = (300 $10) + (400 $5) = $5000

2015:
Nominal GDP = (400 $20) + (200 $2) = $8400
Real GDP = (400 $10) + (200 $5) = $5000
 b
Calculate the GDP deflator for 2005, 2010, and 2015. What is the inflation rate between 2005
and 2010? Between 2010 and 2015?

2005 (base year):

GDP Deflator = ($4500/$4500) 100 = 100

2010:
GDP Deflator = ($6100/$5000) 100 = 122

2015:
GDP Deflator = ($8400/$5000) 100 = 168

GDP Deflator inflation rate in 2010 = ((122 - 100)/100) 100

= 22.0% GDP Deflator inflation rate in 2015 = ((168 -
122)/122) 100 = 37.7%

c
Assume that the market basket for the typical consumer is given by the quantities in 2005.
Calculate the CPI for 2005, 2010, and 2015. What is the inflation rate between 2005 and
2010? Between 2010 and 2015?

Consumer Price index in 2005 = ($4500/$4500) 100 = 100

Consumer Price index in 2010 = ($5000/$4500) 100 = 111.1

CPI Inflation rate in 2010 = ((111.1 - 100)/100) 100 = 11.1%
 Consumer Price index in 2015 = ($5000/$4500) 100 = 111.1
CPI Inflation rate in 2015 = ((111.1 111.1)/111.1) 100 = 0%

d
On an annual basis, how fast has the real economy grown between 2005 and 2015?
Using this rate, how long will it take the economy to double in size? Defend your answer.

The growth rate in real GDP for 2005 - 2015 is (($5000 - $4500)/$4500) 100

= 11.1%. The approximate annual real GDP growth rate is therefore 11.1/10

= 1.11%.

Using the Rule of 70, the number of years for real GDP to double = 70/1.11 = 63.6
year
5.
Explain pros and cons of gross domestic product as a measure of economic development versus
human development index

Gross Domestic Product is the total market value of all final goods and services produced within
a countrys economic territory during a given period. It was first developed in 1934 by Simon
Kuznets for a US Congress report, who said that it cannot be use as a measure for welfare of the
country. From that the United States used the SNA or System of National Accounts which is the
foundation of the GDP to combat the Great Depression in 1930s and to allocate resources
efficiently and effectively for the war effort. As time goes by GDP was more fully develop and
use widely that had a very positive effect in economic well-being, by providing a very useful
economic data. It can be calculated in three ways by adding up income and profits received from
production of goods and services, by adding up expenditures on goods and services and by adding
up the value added by labor and capital when inputs purchased from other producers are
transformed into output. So here are some of the pros and cons of GDP:

STRENGTHS/PROS OF GDP

GDP provides a better analysis or measure of economy activity through its growth rate and
changes in an economy than any other existing measure. It summarizes a whole range of
economic information in and determines the comparative strengths and weaknesses of
various sectors.

GDP helps policy-makers and analysts to easily guide, adjust and implement economic
policy.

GDP serve as accurate barometer of the business climate, where it provides the government
and business useful information to adjust in different kinds of contingency problems like
recession and depression.

GDP serve as a simple proxy for social and economic welfare.

GDP is widely used in different parts of the world that give economist studies in comparing
countries.

WEAKNESSES/CONS OF GDP

GDP does not include non-market activities. These activities are based on production and
consumption that occur outside the market economy that does not have a price attached
like unpaid house workers, volunteer work, barter and the illegal drug trade.

GNP does not include domestic household products or black market.

 GNP does not consider how the wealth of a nation is distributed equally. For example,
GDP provides an estimate of each person share of the market economy but in reality some
people share of the economy is greater than others. This level of unequal distribution of
incomes and consumption and the incidence of poverty cannot be determined by tracking
the GDP.

Some GDP measured expenditures do not contribute to Economic Welfare. It does not
account for any welfare loss or any negative events that results from an event such as a
natural disaster environmental cleanup or reconstruction effort contributes to welfare and
the GDP.

Human Development Index is defined as:

Comparative measure of life expectancy, literacy, education and standards of living for countries
worldwide. It is a standard means of measuring well-being, especially child welfare. It is used to
distinguish whether the country is a developed, a developing or an under-developed country and
also to measure the impact of economic policies on quality of life. (Wikipedia)

So HDI was formed to be able to rank the countries in terms of human development and not just
relying on their GDP or economic factors. These developments are measured according to
standards like personal achievement (education), quality of life (health& freedom), life satisfaction
and happiness. But this indicator has also criticisms or weaknesses like it fail to include any
ecological considerations, have lost its original purpose by not paying much attention to
development from a global perspective, focusing exclusively on national performance and ranking.
It is also criticized by economist for being redundant and adding very little to the development of
countries.
7.
What are the limitations of the consumer price index as a measure of inflation?
The consumer price index, or CPI, is considered one of the most fundamental and critically
important economic indicators, not only in the United States but in virtually every other developed
nation as well. The release of monthly CPI numbers almost invariably has a significant impact on
the financial markets, and unexpectedly high or low numbers often wreak investment havoc. But
despite the CPI being followed so relentlessly , the index is far from perfect as a measure of either
inflation or the cost of living, and it has a number of inherent weaknesses.
The CPI is a weighted index of goods purchased by consumers. While it may constitute a relatively
good measure of price changes in the specific goods purchased in its "basket," a limitation of the
CPI is that the consumer goods it considers do not provide an index that measures all production
or consumption in the economy. Therefore, as a basic economic barometer, the CPI is inherently
flawed.
Even the Bureau of Labor Statistics (BLS) that produces the CPI freely admits that the index does
not factor in substitution. The economic reality is that when certain goods become significantly
more expensive, many consumers find less expensive substitutes. The CPI does not take this
common consumer practice into account but instead presents numbers assuming consumers are
continuing to buy the same amount of increasingly expensive goods.
New products represent another weakness in the CPI. Products do not become included in the
CPI's basket of goods purchased until they become virtually staple purchases by consumers. So
even though new products may be widely purchased and represent considerable consumer
expenditures, they may still be years away from possible inclusion in the calculation of the CPI.
Although the CPI is widely used as the core indicator of inflation, its accuracy in this area has
drawn increasing criticism. For example, during a period when energy costs rose by more than
50% and the prices of some of the most commonly purchased grocery items increased by nearly
30%, the CPI continued to show a very modest inflation rate when other indicators measuring the
buying power of consumers showed a dramatic increase in the cost of living.
Because the CPI is purposely constructed with a focus on the buying habits of urban consumers,
it has often been criticized as not providing an accurate measure of either prices of goods or
consumer buying habits for more rural areas. The CPI also does not provide separate reports
according to different demographic groups.
Any pure price index is flawed by the fact it does not factor in changes in the quality of goods
purchased. Consumers may gain a net benefit from purchasing a product that has risen in price as
a result of significant improvements in the quality of the product and the purposes it serves. But
the CPI has no standard for measuring such quality improvements and therefore reflects only the
increase in price without any appreciation for additional benefits to consumers.
It is important to recognize limitations in the CPI because of its wide use. For example, it provides
the basis for annual cost of living adjustments to Social Security payments and other government-
funded programs.
8.
Explain the main types of unemployment.
Simply put, unemployment is a situation in which an individual in an economy is looking for a job
and can't find one. That said, economists divide unemployment into a number of different
categories, since identifying types of unemployment more precisely sheds some light on why
unemployment occurs and what can be done about it.
Voluntary versus Involuntary Unemployment
At a very basic level, unemployment can be broken down into voluntary unemployment
unemployment due to people willingly leaving previous jobs and now looking for new ones
and involuntary unemployment unemployment due to people getting laid off or fired from their
previous jobs and needing to find work elsewhere. (Note, however, that people who leave jobs and
don't look for new ones are not considered unemployed.) Not surprisingly, economists generally
view involuntary unemployment as a larger problem than voluntary unemployment since voluntary
unemployment likely reflects utility-maximizing household choices.
Unemployment
The easiest type of unemployment to explain is known as frictional unemployment. Frictional
unemployment is unemployment that occurs because it takes workers some time to move from one
job to another. While it may be the case that some workers find new jobs before they leave their
old ones, a lot of workers leave or lose their jobs before they have other work lined up. In these
cases, a worker must look around for a job that it is a good fit for her, and this process takes some
time. During this time, the individual is considered to be unemployed, but unemployment due to
frictional unemployment is usually thought to last only short periods of time and not be specifically
problematic from an economic standpoint. This is particularly true now that technology is helping
both workers and companies make the job search process more efficient.
Frictional unemployment can also occur when students move into the work force for the first time,
when an individual moves to a new city and needs to find work, and when women re-enter the
work force after having children. (Note in the last case, however, that maternity leave doesn't count
as unemployment!)
Cyclical Unemployment
It's probably not surprising that unemployment is higher during recessions and depressions and
lower during periods of high economic growth. Because of this, economists have coined the term
cyclical unemployment to describe the unemployment associated with business cycles occurring
in the economy. Cyclical unemployment occurs during recessions because, when demand for
goods and services in an economy falls, some companies respond by cutting production and laying
off workers rather than by reducing wages and prices. (Wages and prices of this sort are referred
to as "sticky.") When this happens, there are more workers in an economy than there are available
jobs, and unemployment must result.
As an economy recovers from a recession or depression, cyclical unemployment tends to naturally
disappear. As a result, economists usually focus on addressing the root causes of the economic
downturns themselves rather than think directly about how to correct cyclical unemployment in
and of itself.
Structural Unemployment
There are a couple of ways to think about structural unemployment. One way is that structural
unemployment occurs because some labor markets have more workers than there are jobs
available, and for some reason, wages don't decrease to bring the markets into equilibrium. (This
could be because efficiency wages are being paid in an industry, for example.) Another way to
think about structural unemployment is that structural unemployment results when workers
possess skills that aren't in high demand in the marketplace and lack skills that are in high demand.
In other words, structural unemployment results when there is a mismatch with workers' skills and
employers' needs. Structural unemployment is thought to be a pretty significant problem, mainly
because structural unemployment tends to be largely of the long-term variety and retraining
workers is not a cheap or easy task.
Seasonal unemployment is, not surprisingly, unemployment that occurs because the demand for
some workers varies widely over the course of the year. (Pool lifeguards, for example, probably
experience a decent amount of seasonal unemployment.) Seasonal unemployment can be thought
of as a form of structural unemployment, mainly because the skills of the seasonal employees are
not needed in certain labor markets for at least some part of the year. That said, seasonal
unemployment is viewed as less problematic than regular structural unemployment, mainly
because the demand for seasonal skills hasn't gone away forever and resurfaces in a fairly
predictable pattern.
9.
Discuss the cost of unemployment to the economy.

Unemployment is universally recognized as a bad thing. While economists and academics make
convincing arguments that there is a certain natural level of unemployment that cannot be erased,
elevated unemployment imposes significant costs on the individual, the society and the country.
Worse yet, most of the costs are of the dead loss variety where there are no offsetting gains to the
costs that everyone must bear.
The Costs to the Individual
The costs of unemployment to the individual are not hard to imagine. When a person loses his or
her job, there is often an immediate impact to that person's standard of living. Prior to the Great
Recession, the average savings rate in the U.S. had been drifting down towards zero (and
sometimes below), and there are anecdotal reports that the average person is only a few weeks
away from serious financial trouble without a paying job.
Even for those eligible for unemployment benefits and other forms of government assistance (like
food assistance), it is often the case that these benefits replace 50% or less of their regular income.
That means these people are consuming far less than usual. The economic consequences can go
beyond just less consumption, though. Many people will turn to retirement savings in a pinch and
draining these savings has long-term ramifications.
Prolonged unemployment can lead to an erosion of skills, basically robbing the economy of
otherwise useful talents. At the same time, the experience of unemployment (either direct or
indirect) can alter how workers plan for their futures - prolonged unemployment can lead to greater
skepticism and pessimism about the value of education and training and lead to workers being less
willing to invest in the long years of training some jobs require. On a similar note, the absence of
income created by unemployment can force families to deny educational opportunities to their
children and deprive the economy of those future skills.
Last but not least, there are other costs to the individual. Studies have shown that prolonged
unemployment harms the mental health of workers, and can actually worsen physical health and
shorten lifespans.

Costs to Society
The social costs of unemployment are difficult to calculate, but no less real. When unemployment
becomes a pervasive problem, there are often increased calls for protectionism and severe
restrictions on immigration. Protectionism can not only lead to destructive tit-for-tat retaliation
among countries, but reductions in trade harm the economic well-being of all trading partners.

Other social costs include how people interact with each other. Studies have shown that times of
elevated unemployment often correlate both with less volunteerism and higher crime. Elevated
crime makes sense because absent a wage-paying job people may turn to crime to meet their
economic needs or simply to alleviate boredom. The volunteerism decline does not have an
obvious explanation, but could perhaps be tied to the negative psychological impacts of being
jobless or perhaps even resentment at those who do not have a job.

Costs to the Country

The economic costs of unemployment are probably more obvious when viewed through the lens
of the national checkbook. Unemployment leads to higher payments from state and federal
governments for unemployment benefits (in excess of $320 billion through the end of 2010), food
assistance, and Medicaid. At the same time, those governments are no longer collecting the same
levels of income tax as before - forcing the government to borrow money (which defers the costs
and impacts of unemployment into the future) or cut back on other spending (perhaps exacerbating
the bad economic situation).
Unemployment is also a dangerous state for the macro economy. Typically, a large part of the
macro economy produces goes to personal consumption and unemployed workers. Even those
getting government support cannot spend at prior levels. The production of those workers leaves
the economy which reduces the GDP and moves the country away from the efficient allocation of
its resources. For those who subscribe to Jean-Baptiste Say's theory that "products are paid for by
products," that is a serious issue.
It is also worth noting that companies pay a price for high unemployment as well. Unemployment
benefits are financed largely by taxes assessed on businesses. When unemployment is high, states
will often look to replenish their coffers by increasing their taxation on businesses - counter-
intuitively discouraging companies from hiring more workers. Not only do companies face less
demand for their products, it is also more expensive for them to retain or hire workers.

The Bottom Line

Governments rightly fret about the consequences of inflation, but unemployment is likewise a
serious issue. Apart from the social unrest and disgruntlement that unemployment can produce in
the electorate, high unemployment can have a self-perpetuating negative impact on businesses and
the economic health of the country.
Worse still, some of the worst effects of unemployment are both subtle and very long-lasting -
consumer and business confidence are key to economic recoveries and workers must feel confident
in their future to invest in developing the skills (and building the savings) that the economy needs
to grow in the future. The costs of unemployment go far beyond the accumulated sums handed out
as unemployment insurance benefits.
10.

What are the key differences between consumer price index and gross domestic product deflator?

CPI and GDP deflator generally seem to be the same thing but they have some few key differences.
Both are used to determine price inflation and reflect the current economic state of a particular
nation.

GDP Deflator takes into account goods that are produced domestically. It does not bother with
imported goods and it reflects the prices of all the commodities, services included. The GDP
deflator is calculated quarterly and it weights may change per calculation.

GDP is an abbreviation of Gross Domestic Product which is the overall value of all final goods
and services made within the borders of a country in specified period. GDP has two types the:
Nominal GDP and the Real GDP. The ratio of the two values is the GDP deflator.

If expressed mathematically,

GDP Deflator = (Nominal GDP/Real GDP) x 100

Essentially, the GDP deflator compares the price level in the current year to level in the base year.

There are so many price indices out there and GDP is unlike some of them that are based on a
predetermined basket of goods and services. In the GDP deflator, the so-called basket in a year is
weighted by the market value of all the consumption of each good therefore it is allowed to change
with peoples investment and expenditure patterns since people do respond to varying prices.

CPI, which is short for Consumer Price Index, indicates the prices of a representative basket of
commodities procured by the consumers. It uses a fixed basket of goods and services and is a
widely used measure of the cost of living faced by consumers of a nation. Like the GDP deflator,
it also compares prices of the current period to a base period.

CPI tends to consider insignificant goods, even the outdated ones that are not really purchased by
the consumers anymore. Nevertheless, they are still considered for pricing in the fixed basket.
Consumption goods are the main priority of the CPI measure. The prices of other items used in
production are not considered as well as the prices of investment goods. Only consumer items are
taken into account, the machines and the industrial equipment that are used to make them are not
considered.

As you can see, GDP deflator is not identical with the CPI but provides an alternative to each other
as a measure of inflation. Over long periods of time, both provide similar numbers, but they can
diverge in shorter periods.

In sum, the three key differences between the CPI and the GDP deflator are:
1. The GDP deflator measures a changing basket of commodities while CPI always indicates the
price of a fixed representative basket.

2. GDP deflator frequently changes weights while CPI is revised very infrequently.

3. CPI will consider imported goods because they are still considered as consumer goods while
GDP deflator will only contain prices of domestic goods.
11.
Determine which of the following would be counted in the spending approach of GDP, and which
would not be counted. Identify the category under which it would fall (C, I, G, NX, or not counted).

a. The housecleaning services of a stay-at-home mom.

b. The housecleaning services of the Merry Maids company.
c. The babysitting services of a babysitter whose earnings are kept off the books and not
reported to the tax authorities.
d. A brand new house built and sold this year.
e. A new car made by Ford in the U.S., and sold to a household in the U.S.
f. A new car made by Ford in the U.S, and sold in Mexico.
g. A 2002 used Ford car.
h. 3 shares of Ford Motor Company stock
i. A new car made by Ford in the U.S. but not sold by the end of the year.
j. A new car added to the fleet of taxis of Mr. Taxi Company.
k. A new bridge to accommodate all the new and used cars and taxis on the road.

Answer:
a. Not counted
b. C
c. Not counted
d. I
e. C
f. NX (exports)
g. Not counted
h. Not counted
i. I
j. I
k. G
12.
The country of Atlantis produces two goods: footballs and basketballs. Below is a table showing
prices and quantities of output for three years:
Year Price of Quantity of Price of Quantity of
Footballs Footballs Basketballs Basketballs
1 10 120 12 200
2 12 200 15 300
3 14 180 18 275

Calculate for each year the nominal GDP, real GDP and GDP deflator.

Answers:
Nominal GDP in Year 1 = ($10 120) + ($12 200) = $3,600
Nominal GDP in Year 2 = ($12 200) + ($15 300) = $6,900
Nominal GDP in Year 3 = ($14 180) + ($18 275) = $7,470
Using Year 1 as the Base Year:
Real GDP in Year 1 = ($10 120) + ($12 200) = $3,600
Real GDP in Year 2 = ($10 200) + ($12 300) = $5,600
Real GDP in Year 3 = ($10 180) + ($12 275) = $5,100 (Note that nominal GDP rises from
Year 2 to Year 3, but real GDP falls.)
GDP deflator for Year 1 = ($3,600/$3,600) 100 = 1 100 = 100
GDP deflator for Year 2 = ($6,900/$5,600) 100 = 1.2321 100 = 123.21
GDP deflator for Year 3 = ($7,470/$5,100) 100 = 1.4647 100 = 146.47