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# HW1AnswerKey - ECON 420 Fall 2008 Homework 1 Due in class...

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Homework 1 Due in class on September 3, 2008 1. Consider an economy that produces and consumes bread and automobiles. In the following table are data for two different years.(15 points) Year 2000 Year 2010 ____________________________________________________________________________________ _ Price of an automobile \$50,000 \$60,000 Price of a loaf of bread \$10 \$20 Number of automobiles purchased 100 120 Number of loaves of bread purchased 500,000 400,000 a. Using the year 2000 as the base year, compute the following statistics for each year: Nominal GDP, Real GDP, the implicit price deflator for GDP, and a fixed-weight price index such as CPI. Nominal GDP (2000) = \$50,000*100+\$10*500,000 = \$10,000,000 Nominal GDP (2010) = \$60,000*120+\$20*400,000 = \$15,200,000 Real GDP (2000) = \$50,000*100+\$10*500,000 = \$10,000,000 Real GDP (2010) = \$50,000*120+\$10*400,000 = \$10,000,000 GDP deflator (2000) = (\$1,000,000/\$1,000,000)*100%=100% GDP deflator (2010) = (\$1,520,000)/(\$1,000,000)*100%=152% CPI (2000) = 100% CPI (2010) = ((\$60,000*100+\$20*500,000)/(1,000,000))*100%=160% b. How much have prices risen between year 2000 and year 2010? Compare the answers given by the Laspeyres and Paasche price indices. Explain the difference. Laspeyres price index implies an inflation rate of 60% while Paasche price index implies an inflation rate of 52%. The Paasche index implies a lower inflation as it reflects the substitution effect of a price increase. c. Suppose that you are senator writing a bill to index Social Security and federal pensions. That is, your bill will adjust these benefits to offset changes in the cost of living. Will you use the GDP deflator or the CPI? Why? The choice between CPI and GDP deflator is a difficult one to make. CPI tends to overstate inflation as it fails to account the substitution effect of a price increase. On the other hand, GDP deflator fails to reflect the decrease in welfare due to inflation. Thus GDP deflator underestimates inflation. 1

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HW1AnswerKey - ECON 420 Fall 2008 Homework 1 Due in class...

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