Problem Set I Solution Macroeconomics and Economic Policy IIM, Ahmedabad

Topics: GDP, Inflation, BoP, Money 28th Oct, 2012

MEP Problem Set I Solution

Q1. Say, in coming February, 2013 the Central Statistical Organisation comes out with its Income
estimates and according to the released numbers the growth in GDP over the year 2012 - 2013 has
been 10%.

a) What are the possible practical problems in interpreting the 10% growth figure released in February?
• Feb estimates are Advanced Estimates and subject to revisions - often significant.
• Feb estimates do/can not taken into account any adverse external shock that may happen in
March.
b) Under what circumstances can one say that the real incomes have gone up by 10%?
YN ominal
YReal =
P

Taking logs gives: ln(YReal ) = ln(YN ominal ) − ln(P )

dYReal dYN ominal dP

Taking total derivatives: = −
YReal YN ominal P

dYReal dYN ominal dP

⇒ = −
YReal YN ominal P
|{z}
| {z } | {z }
Real GDP Growth Nominal GDP Growth Inflation
i.e. Real GDP growth is same as Nominal GDP iff only inflation over the period is zero.
c) Can one say that the standards of living in the last year have improved by 10%? Under what
conditions can one say that?
• This leaves a lot of scope for blah/globe, and I am sure this is one question you would not
want too much help from me. If still in doubt, go back to Chapter 1 of your book.

Q2. Consider an economy where people only consume apples (A) and oranges (O). In a particular
year (Year 1), when cost of an apple is Rs. 5 (PA1 ) and cost of an orange is Rs. 10 (PO1 ), people
consume 100,000 apples (QA1 ). In the year after (Year 2), when the price of an apple has gone up to
Rs. 10 (PA2 ) and that of an orange has gone down to Rs. 5 (PO2 ) , they consume 100,000 oranges
(QO2 ).
a) Taking Year 1 to be the base year, find CPI for both years.
• CPI uses base year’s consumption basket to find out weights for each good:
PA2 × QA1 + PO2 × QO1
CP I2 =
PA1 × QA1 + PO1 × QO1
10 × 100000 + 5 × 0
=
5 × 100000 + 10 × 0
=2

PA1 × QA1 + PO1 × QO1

CP I1 =
PA1 × QA1 + PO1 × QO1
=1
Problem Set I Solution Macroeconomics and Economic Policy IIM, Ahmedabad

b) Given the above values of CPI, what has been the inflation over the year?
• CPI has doubled during the year, i.e. prices have doubled.
c) What has been economy’s nominal spending in both years? How does it change from Year 1 to
Year 2?

• Nominal spending in a year is the total value of output produced. Then:

Nominal Spending1 = PA1 × QA1 + PO1 × QO1

= 5 × 100000 + 10 × 0 = 500, 000

Nominal Spending2 = PA2 × QA2 + PO2 × QO2

= 10 × 0 + 5 × 100000 = 500, 000

• Nominal spending remains the same over the year.

d) With Year 1 as the base year, what about economy’s real spending?
• Real spending pertains to the total output produced at base year’s prices. In year 1, of
course, real spending would be same as the nominal spending, i.e.:

Real Spending1 = PA1 × QA1 + PO1 × QO1

= 5 × 100000 + 10 × 0 = 500, 000

Real Spending2 = PA1 × QA2 + PO1 × QO2

= 5 × 0 + 10 × 100000 = 1, 000, 000

• Real spending has doubled over the year.

e) What is the GDP Deflator for each year?

• Deflator is given by the ratio of nominal spending (current prices) and real spending (constant
prices)

Nominal Spending2
GDP Deflator =
Real Spending2

500, 000
= = 0.5
1, 000, 000

f) Suppose the popluation of the economy is indifferent between eating apples and oranges, has their
cost of living increased? By how much? What does this say about Laspeyre’s Index as a measure
of welfare?
• If the population is indifferent between apples and oranges, then, of course, the cost of living
hasn’t changed. Laspeyre’s index, however, tells that the cost of living has doubled. This is
because CPI only takes into account the fact that the price of apples has increased but not
the fact consumption of apples has decreased (as in this case, gone to zero). That is, CPI
as measured by the Laspeyre’s index, overstates inflation. GDP deflator, on the other hand,
understates inflation.
Problem Set I Solution Macroeconomics and Economic Policy IIM, Ahmedabad

Q3. Given the following macroeconomic data in INR crores:

• Private Investment = 800, 000

• Government expenditure on goods and services = 600, 000
• GNP at Market Prices = 4, 000, 000
• Current A/c Balance = −40, 000

• Transfer Payments from Government = 50, 000

• Interest Payments from Government = 30, 000
• Factor Income from Abroad = 14, 000

• Factor Payments made to Expatriates in India = 90, 000

Assuming the above describes all the aggregate information you need to know about the economy,
find the following:
a) Net Factor Income from Abroad (NFIA)

NFIA = Factor Income from Abroad − Factor Payments made to Expats

= 14000 − 90000 = −76, 000

b) GDP

GDP = GNP - NFIA

= 4000000 − (−76000) = 4, 076, 000

c) Consumption

C = Y - I - G - (X - M)
= 4076000 − 800000 − 600000 − (−40000) = 2, 716, 000

d) Net Exports

Net Exports = Current Account Balance

= −40, 000

e) Private Savings

Private Savings = Private Disposable Income − Consumption

= GNP + Net Transfers from the Government and Abroad − Consumption
= GNP + Transfer Payments from the Government
+ Interest Payments from the Government − Consumption
= 4076000 + 50000 + 30000 − 2716000 = 1, 44, 0000

f) Government Savings

Government Savings = Net Transfers to the Government − Government Expenditure

= - Transfer Payments from the Government - Interest Payments from the Government
− Government Expenditure
= −50000 − 30000 − 600000 = −680, 000
Problem Set I Solution Macroeconomics and Economic Policy IIM, Ahmedabad

g) Does Savings = Investment identity hold in this economy?

Total Savings = Private Savings + Government Savings + Foreign Savings
= Private Savings + Government Savings − Current Account Balance
= 1440000 + (−680000) − (−40000)
= 800, 000
= Total Investment

Q4. Consider an economy that produces only three types of goods: Austin Martin (A), BMW (B),
and Corvette (C), and the production (Q) and the price (P ) of each in the base year (0) was the
following:

• QA0 = 15, 000, PA0 = 10 million INR

• QB0 = 30, 000, PB0 = 15 million INR
• QC0 = 40, 000, PC0 = 20 million INR

The production and price of the three goods in the current year (1) were found to be:
• QA1 = 20, 000, PA1 = 15 million INR
• QB1 = 120, 000, PB1 = 25 million INR
• QC1 = 90, 000, PC1 = 12 million INR

Assuming this economy only makes A, B and C :

a) Find the nominal and the real GDP in both years.
Nominal GDP0 = PA0 × QA0 + PB0 × QB0 + PC0 × QC0
= 10 × 15000 + 15 × 30000 + 20 × 40000 = 1400000

Real GDP0 = Nominal GDP0 = 1400000

Nominal GDP1 = PA1 × QA1 + PB1 × QB1 + PC1 × QC1

= 15 × 20000 + 25 × 120000 + 12 × 90000 = 4380000

Real GDP1 = PA0 × QA1 + PB0 × QB1 + PC0 × QC1

= 10 × 20000 + 15 × 120000 + 20 × 90000 = 3800000

b) What is the percentage change in the real GDP? What is the GDP deflator?
Real GDP1 − Real GDP0
Percentage change in Real GDP =
Real GDP0

3800000 − 1400000
= = 71.43%
1400000

Nominal GDP1
GDP Deflator =
Real GDP1

4380000
= = 1.1526
3800000
Problem Set I Solution Macroeconomics and Economic Policy IIM, Ahmedabad

c) Find the price increase using the Laspeyre’s index.

PA1 × QA0 + PB1 × QB0 + PC1 × QC0

CP I =
PA0 × QA0 + PB0 × QB0 + PC0 × QC0

15 × 15000 + 25 × 30000 + 12 × 40000

=
10 × 15000 + 15 × 30000 + 20 × 40000

1455000
= = 1.0393
1400000

⇒ InflationCP I = 3.93%

d) Comment on the price increase between the current and the base year. Which is the bigger con-
tributing factor - increase in production or increase in price levels?
• GDP Deflator keeps prices constant (i.e. measures the change due to change in quantity)
and CPI keeps quantity constant (i.e. measures the change due to change in prices). Because
GDP Deflator = 1.1526 > CPI = 1.0393, the bigger contributing factor is quantity.

Q5. A computer company (CC) has a 20 crore factory in Bangalore and you are told it built 2 crore
worth of computer parts over the year. You are also told that its labour cost was 1 crore, and that
it paid taxes worth 10 lacs. CC sells all its output to a computer games company (CG). Using parts
obtained from CC, CG makes 4 high-end gaming consoles at a cost of 80 lacs each (50 lacs worth of
components, 20 lacs worth of labour costs and 10 lacs worth of tax). It sells three of those high-end
consoles at 1 crore each, and one of them remains unsold and remains as inventory. CG’s games
making factory is worth 30 crore. Find contribution of these transactions to an economy’s GDP.
Show that all three approaches (Expenditure, Income and Output) give the same answer.

Contribution to GDPOutput = Total Output Produced + Change in Inventory

= Final Output ProducedCC + Final Output ProducedCG

+ Change in InventoryCG

= 0 + 3 × 100 + 1 × 100 = 400 lacs

Contribution to GDPIncome = Wages + Profits + Taxes

= (Wages + Profits)CC + (Wages + Profits)CG + Taxes

= (100 + 90) + (80 + 80) + (10 + 40) = 400 lacs

Contribution to GDPExpenditure = Final Consumption Expenditure on Gaming Consoles

+ Final Investment (Inventory) Expenditure on Gaming Consoles

= 3 × 100 + 1 × 100 = 400 lacs