4.

(a)

A. Suppose that an economy produces and consumes only two commodities-say X and Y
and the following data is given

Year Commodity X Commodity y

Price Quantity Price Quantity
2014-15 K 50 100 unit K 10 500
2015-16 K 60 150 unit K 20 450

i. Assuming the year 2014-15 as the base year, calculate the following statistics:

nominal GDP, real GDP, GDP deflator and CPI for the year 2015-16.

ii. CPI is used to the index social security benefits in order to adjust these benefits with
changes in the cost of living, but CPI tends to overstate inflation

iii. Describe the measurement problems that make CPI overstate inflation. Write down the
differences between CPI and GDP deflator.

Ans:

(i)

Nominal GDP = ∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦)

= (2015-2016 price of commodity X x 2015-2016 quantity of commodity X )

Nominal GDP for 2015-2016
+ (2015-2016 price of commodity Y x 2015-2016 quantity of commodity Y)
= (K 60 x 150) + ( K 20 X 450)
= K 9,000 + K 9,000
= K 18,000

Real GDP = ∑(Base year price x current quantity)

= (2014-2015 price of commodity X x 2015-2016 quantity of commodity X )

Real GDP for 2015-2016
+ (2014-2015 price of commodity Y x 2015-2016 quantity of commodity Y)
= (K 50 x 150) + ( K 10 X 450)
= K 7,500 + K4,500
= K 12,000

Nomial GDP
GDP deflator =
Real GDP

Nominal GDP for 2015−2016

GDP deflator for 2015-2016 =
Real GDP for 2015−2016

Page 1 of 13
 K 18,000
=
K 12,000
= 1.5

∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 𝑋 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 )

CPI =
∑ 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑋 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
x 100

(2015−2016 price of commodity X x 2014−2015 quantity of commodity X )

CPI for 2015- + (2015−2016 price of commodity Y x 2014−2015 quantity of commodity Y)
2016
= (2014−2015 price of commodity X x 2014−2015 quantity of commodity X ) 𝑋100
+ (2014−2015 price of commodity Y x 2014−2015 quantity of commodity Y)

(𝐾 60 𝑥 100)+(𝐾20 𝑥 500)
= (𝐾 50 𝑥 100)+(𝐾10 𝑥 500)
x 100

𝐾 16,000
= x 100
𝐾 10,000

= 160 %

(ii)

CPI & Its measurement problems [pp.32-33]

A closely watched measure of inflation is CPI. Policymakers monitor the CPI when choosing monetary policy.
Many laws and private contracts have cost-of-living allowances, called COLAs, which use the CPI to adjust for
changes in the price level.
The CPI tends to overstate inflation. Why?

One problem is the substitution bias. Because the CPI measures the price of a fixed basket of goods, it does
not reflect the ability of consumers to substitute toward goods whose relative prices have fallen.

A second problem is the introduction of new goods.

A third problem is unmeasured changes in quality.

(iii)

Different between CPI and GDP deflator are,

First,

 GDP deflator measures the prices of all goods and services produced,
 CPI measures the prices of only the goods and services bought by consumers.

Second,

 GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP
 Imported goods are includes in CPI

Third,

Page 2 of 13
  GDP deflator assigns changing weights and GDP deflator allows the basket of goods to change over
time as the composition of GDP changes.
 CPI assigns fixed weights to the prices of different goods and CPI is computed using a fixed basket of
goods

B. For an economy producing three commodities-say X,Y and Z, the following data is given.
(20 marks)

Year Commodity X Commodity Y Commodity Z

Price Quantity Price Quantity Price Quantity
2010 K 1000 4000 units K 100 60000 units K 400 5000 units
2011 K 1500 5000 units K 120 50000 units K 500 5000 units

i. Assuming the year 2010 as the base year, calculate the following statistics:

nominal GDP, real GDP, GDP deflator and CPI for the year 2011.

ii. If you have to write a bill to index social security and government pension in order to adjust
these benefits with changes in the cost of living, which one will you use- the GDP deflator or
the CPI? Give reason.

iii. Write down the differences between CPI and GDP deflator.

Ans:
(i)

Nominal GDP = ∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦)

= (𝑃 2011 2011 2011 2011

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 ) + (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 ) +
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 2011
(𝑃 2011 2011
𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 )

= ( K 1,500 x 5,000) + (K 120 x 50,000 ) + (K 500 x 5,000 )

= K (7,500,000 + 6,000,000 + 2,500,000 )
= K 16,000,000

Real GDP = ∑(𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑥 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑞𝑢𝑎𝑛𝑖𝑡𝑖𝑡𝑦)

= (𝑃 2010 2011 2010 2011

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 ) + (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 ) +
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 2011
(𝑃 2010 2011
𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 )

= (K 1,000 x 5,000) + (K 100 x 50,000) + (K 400 x 5,000 )

= K ( 5,000,000 + 5,000,000 + 2,000,000)

Page 3 of 13
 = K 12,000,000

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
GDP deflator =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 2011

𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 2011 =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 2011
𝐾 16,000,000
=
𝐾 12,000,000

= 1.33

∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 𝑋 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 )

CPI =
∑ 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑋 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
x 100

(𝑃 2011 2010 2011 2010 2011 2010

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 )+(𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )+ (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 )
𝐶𝑃𝐼 2011 = x 100
(𝑃 2010 2010 2010 2010 2010 2010
𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 )+(𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )+ (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 )

(𝐾 1500 𝑥 4000)+(𝐾 120 𝑥 60000)+(𝐾 500 𝑥 5000 )

= (𝐾 x 100
1000 𝑥 4000 )+( 𝐾 100 𝑥 60000)+(𝐾 400 𝑥 5000)

𝐾 (6,000,000 + 7,200,000+2,500,000)
= x 100
𝐾 (4,𝑜𝑜𝑜,𝑜𝑜𝑜+6,000,000+2,000,000 )

𝐾 15,700,000
= x 100
𝐾 12,000,000

= 130.8 %

(ii)

As per the question, I will use the CPI for write a bill to index social and government pension in order to adjust
these benefits with changes in the cost of living. Because CPI measure the cost of living and closely watched
measure of inflation and then social security benefits are adjusted automatically every tear so that inflation
will not erode the living standard of the elderly.
(iii)

Different between CPI and GDP deflator are,

First,

 GDP deflator measures the prices of all goods and services produced,
 CPI measures the prices of only the goods and services bought by consumers.
Page 4 of 13
Second,

 GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP
 Imported goods are includes in CPI
Third,

 GDP deflator assigns changing weights and GDP deflator allows the basket of goods to change over
time as the composition of GDP changes.
 CPI assigns fixed weights to the prices of different goods and CPI is computed using a fixed basket of
goods

C. For an economy producing three commodities-say X,Y and Z, the following data is given.
(20 marks)

Year Commodity X Commodity Y Commodity Z

Price Quantity Price Quantity Price Quantity
2014-2015 K 1000 4000 units K 100 60000 units K 400 5000 units
2015-2016 K 1500 5000 units K 120 50000 units K 500 5000 units

i. Assuming the year 2014-2015 as the base year, calculate the following statistics:
nominal GDP, real GDP, GDP deflator and CPI for the year 2015-2016.

ii. CPI is used to the index social security benefits in order to adjust these benefits with
changes in the cost of living, but CPI tends to overstate inflation. Describe the measurement
problems that make CPI overstate inflation.

iii. Write down the differences between CPI and GDP deflator.

Ans:

(i)

Nominal GDP = ∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦)

= (𝑃 2015−2016 2015−2016 2015−2016 2015−2016

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 ) + (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 ) +
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 2015−2016
(𝑃 2015−2016 2015−2016
𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 )

= ( K 1,500 x 5,000) + (K 120 x 50,000 ) + (K 500 x 5,000 )

= K (7,500,000 + 6,000,000 + 2,500,000 )
= K 16,000,000

Real GDP = ∑(𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑥 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑞𝑢𝑎𝑛𝑖𝑡𝑖𝑡𝑦)

= (𝑃 2014−2015 2015−2016 2014−2015 2015−2016

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 ) + (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 ) +
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 2015−2016 2014−2015 2015−2016
(𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 )
Page 5 of 13
 = (K 1,000 x 5,000) + (K 100 x 50,000) + (K 400 x 5,000 )
= K ( 5,000,000 + 5,000,000 + 2,000,000)
= K 12,000,000

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
GDP deflator =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 2015−2016

𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 2015−2016 =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 2015−2016
𝐾 16,000,000
=
𝐾 12,000,000

= 1.33

∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 𝑋 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 )

CPI =
∑ 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑋 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
x 100

(𝑃 2015−2016 2014−2015 2015−2016 2014−2015 2015−2016 2014−2015

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 )+(𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )+ (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 )
= x
𝐶𝑃𝐼 2015−2016 (𝑃 2014−2015 2014−2015 2014−2015 2014−2015 2014−2015 2014−2015
𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 )+(𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )+ (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 )
100
(𝐾 1500 𝑥 4000)+(𝐾 120 𝑥 60000)+(𝐾 500 𝑥 5000 )
= (𝐾 x 100
1000 𝑥 4000 )+( 𝐾 100 𝑥 60000)+(𝐾 400 𝑥 5000)

𝐾 (6,000,000 + 7,200,000+2,500,000)
= x 100
𝐾 (4,𝑜𝑜𝑜,𝑜𝑜𝑜+6,000,000+2,000,000 )

𝐾 15,700,000
= x 100
𝐾 12,000,000

= 130.8 %

(ii)

CPI & Its measurement problems [pp.32-33]

A closely watched measure of inflation is CPI. Policymakers monitor the CPI when choosing monetary policy.
Many laws and private contracts have cost-of-living allowances, called COLAs, which use the CPI to adjust for
changes in the price level.

The CPI tends to overstate inflation. Why?

One problem is the substitution bias. Because the CPI measures the price of a fixed basket of goods, it does
not reflect the ability of consumers to substitute toward goods whose relative prices have fallen.

Page 6 of 13
A second problem is the introduction of new goods.

A third problem is unmeasured changes in quality.

(iii)

Different between CPI and GDP deflator are,

First,

 GDP deflator measures the prices of all goods and services produced,
 CPI measures the prices of only the goods and services bought by consumers.
Second,

 GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP
 Imported goods are includes in CPI
Third,

 GDP deflator assigns changing weights and GDP deflator allows the basket of goods to change over
time as the composition of GDP changes.
 CPI assigns fixed weights to the prices of different goods and CPI is computed using a fixed basket of
goods

D. For an economy producing three commodities-say X,Y and Z, the following data is given.
(20 marks)

Year Commodity X Commodity Y Commodity Z

Price Quantity Price Quantity Price Quantity
2010-2011 K 1000 4000 units K 100 60000 units K 400 5000 units
2014-2015 K 1200 5000 units K 150 50000 units K 600 5000 units

i. Assuming the year 2010-2011 as the base year, calculate the following statistics:
nominal GDP, real GDP, GDP deflator and CPI for the year 2014-2015.

ii. CPI is used to the index social security benefits in order to adjust these benefits with
changes in the cost of living, but CPI tends to overstate inflation. Describe the measurement
problems that make CPI overstate inflation.

iii. Write down the differences between CPI and GDP deflator.
Page 7 of 13
Ans:

(i)

Nominal GDP = ∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦)

= (𝑃 2014−2015 2014−2015 2014−2015 2014−2015

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 ) + (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 ) +
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 2014−2015 2014−2015 2014−2015
(𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 )
= ( K 1,200 x 5,000) + (K 150 x 50,000 ) + (K 600 x 5,000 )
= K (6,000,000 + 7,500,000 + 3,000,000 )
= K 16,500,000

Real GDP = ∑(𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑥 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑞𝑢𝑎𝑛𝑖𝑡𝑖𝑡𝑦)

= (𝑃 2010−2011 2014−2015 2010−2011 2014−2015

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 ) + (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 ) +
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 2014−2015
(𝑃 2010−2011 2014−2015
𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 )

= (K 1,000 x 5,000) + (K 100 x 50,000) + (K 400 x 5,000 )

= K ( 5,000,000 + 5,000,000 + 2,000,000)
= K 12,000,000

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
GDP deflator =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 2015−2016

𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 2015−2016 =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 2015−2016
𝐾 16,500,000
=
𝐾 12,000,000

= 1.375

∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 𝑋 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 )

CPI =
∑ 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑋 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
x 100

(𝑃 2014−2015 2010−2011 2014−2015 2010−2011 2014−2015 2010−2011

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 )+(𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )+ (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 )
= x
𝐶𝑃𝐼 2014−2015 (𝑃 2010−2011 2010−2011 2010−2011 2010−2011 2010−2011 2010−2011
𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 )+(𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )+ (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑍 )
100
(𝐾 1200 𝑥 4000)+(𝐾 150 𝑥 60000)+(𝐾 600 𝑥 5000 )
= (𝐾 x 100
1000 𝑥 4000 )+( 𝐾 100 𝑥 60000)+(𝐾 400 𝑥 5000)

Page 8 of 13
 𝐾 (4,800,000 + 9,000,000+3,000,000)
= x 100
𝐾 (4,𝑜𝑜𝑜,𝑜𝑜𝑜+6,000,000+2,000,000 )

𝐾 16,800,000
= x 100
𝐾 12,000,000

= 140 %

(ii)

CPI & Its measurement problems [pp.32-33]

A closely watched measure of inflation is CPI. Policymakers monitor the CPI when choosing monetary policy.
Many laws and private contracts have cost-of-living allowances, called COLAs, which use the CPI to adjust for
changes in the price level.

The CPI tends to overstate inflation. Why?

One problem is the substitution bias. Because the CPI measures the price of a fixed basket of goods, it does
not reflect the ability of consumers to substitute toward goods whose relative prices have fallen.

A second problem is the introduction of new goods.

A third problem is unmeasured changes in quality.

(iii)

Different between CPI and GDP deflator are,

First,

 GDP deflator measures the prices of all goods and services produced,
 CPI measures the prices of only the goods and services bought by consumers.
Second,

 GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP
 Imported goods are includes in CPI
Third,

 GDP deflator assigns changing weights and GDP deflator allows the basket of goods to change over
time as the composition of GDP changes.
 CPI assigns fixed weights to the prices of different goods and CPI is computed using a fixed basket of
goods

E. Consider an economy produces and consumes only two commodities-say X and Y and
the following data is given. (20 marks)

Year Commodity X Commodity Y Commodity Z

Page 9 of 13
 Price Quantity Price Quantity Price Quantity
2000 K 1000 4000 units K 100 60000 units K 500 8000 units
2010 K 1200 5000 units K 140 50000 units K 700 5000 units

i. Assuming the year 2000 as the base year, calculate the following statistics:

nominal GDP, real GDP, GDP deflator and CPI for the year 2010.

ii. What are the differences between CPI and GDP deflator ?

iii. If you have to write a bill to index social security and government pensions and your bill
will adjust these benefits to offset changes in the cost of living, which one will you use- the
GDP deflator or the CPI? Give reason.

Ans:

(i)

Nominal GDP = ∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦)

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 2010 = (𝑃 2010 2010 2010 2010

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 ) + (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )

= ( K 1,200 x 5,000) + (K 140 x 50,000 )

= K (6,000,000 + 7,000,000)
= K 13,000,000

Real GDP = ∑(𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑥 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑞𝑢𝑎𝑛𝑖𝑡𝑖𝑡𝑦)

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 2010 = (𝑃 2000 2010 2000 2010

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 ) + (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )

= (K 1,000 x 5,000) + (K 100 x 50,000)

= K ( 5,000,000 + 5,000,000)
= K 12,000,000

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
GDP deflator =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 2010

𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 2010 =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 2010
𝐾 13,000,000
=
𝐾 12,000,000

= 1.083

Page 10 of 13
 ∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 𝑋 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 )
CPI =
∑ 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑋 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
x 100

(𝑃 2010 2000 2010 2000

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 )+(𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )
𝐶𝑃𝐼 2010 = x 100
(𝑃 2000 2000 2000 2000
𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 )+(𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )

(𝐾 1200 𝑥 4000)+(𝐾 140 𝑥 60000)

= (𝐾 x 100
1000 𝑥 4000 )+( 𝐾 100 𝑥 60000)

𝐾 (4,800,000 + 8,400,000)
= x 100
𝐾 (4,𝑜𝑜𝑜,𝑜𝑜𝑜+6,000,000 )

𝐾 13,200,000
= x 100
𝐾 12,000,000

= 1.1 %

(ii)

Different between CPI and GDP deflator are,

First,

 GDP deflator measures the prices of all goods and services produced,
 CPI measures the prices of only the goods and services bought by consumers.
Second,

 GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP
 Imported goods are includes in CPI
Third,

 GDP deflator assigns changing weights and GDP deflator allows the basket of goods to change over
time as the composition of GDP changes.
 CPI assigns fixed weights to the prices of different goods and CPI is computed using a fixed basket of
goods

(iii)

As per the question, I will use the CPI for write a bill to index social security and government pension in order
to adjust these benefits to offset changes in the cost of living. Because CPI measure the cost of living and
closely watched measure of inflation and then social security benefits are adjusted automatically every tear so
that inflation will not erode the living standard of the elderly.

Page 11 of 13
F. Suppose that an economy produces and consumes only two commodities-say X and Y
and the following data is given

Year Commodity X Commodity y

Price Quantity Price Quantity
1990 K 50 100 unit K 10 500
2000 K 60 150 unit K 20 450

i. Assuming the year 1990 as the base year, calculate the following statistics:

nominal GDP, real GDP, GDP deflator and CPI for the year 2000.

ii. What are the differences between CPI and GDP deflator ?

iii. If you have to write a bill to index social security in order to offset changes in the cost of
living, which one will you use- the GDP deflator or the CPI? Give reason.

Ans:

(i)

Nominal GDP = ∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑥 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦)

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 2000 = (𝑃 2000 2000 2000 2000

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 ) + (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )

= ( K 60 x 150) + (K 20 x 450 )
= K (9,000 + 9,000)
= K 18,000

Real GDP = ∑(𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑥 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑞𝑢𝑎𝑛𝑖𝑡𝑖𝑡𝑦)

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 2000 = (𝑃 1990 2000 1990 2000

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 ) + (𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )

= (K 50 x 150) + (K 10 x 450)
= K ( 7,500 + 4,500)
= K 12,000

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
GDP deflator =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 2000

𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 2000 =
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 2000
𝐾 18,000
=
𝐾 12,000

Page 12 of 13
 = 1.5

∑(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒 𝑋 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 )

CPI =
∑ 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑋 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
x 100

(𝑃 2000 1990 2000 1990

𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 )+(𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )
𝐶𝑃𝐼 2000 = x 100
(𝑃 1990 1990 1990 1990
𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 𝑥 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑥 )+(𝑃 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 𝑄 𝐶𝑜𝑚𝑚𝑜𝑑𝑖𝑡𝑦 𝑌 )

(𝐾 60 𝑥 100)+(𝐾 20 𝑥 500)
= (𝐾 x 100
50 𝑥 100 )+( 𝐾 10 𝑥 500)

𝐾 (6,000 + 10,000)
= x 100
𝐾 (5,𝑜𝑜𝑜+5,000 )

𝐾 16,000
= x 100
𝐾 10,000

= 1.6 %

(ii)

Different between CPI and GDP deflator are,

First,

 GDP deflator measures the prices of all goods and services produced,
 CPI measures the prices of only the goods and services bought by consumers.
Second,

 GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP
 Imported goods are includes in CPI
Third,

 GDP deflator assigns changing weights and GDP deflator allows the basket of goods to change over
time as the composition of GDP changes.
 CPI assigns fixed weights to the prices of different goods and CPI is computed using a fixed basket of
goods

(iii)
As per the question, I will use the CPI for write a bill to index social security in order to offset changes in the
cost of living. Because CPI measure the cost of living and closely watched measure of inflation and then social
security benefits are adjusted automatically every tear so that inflation will not erode the living standard of
the elderly.

Page 13 of 13