Problem 5 A small nation idolizes the TV s... [FREE SOLUTION] (2024)

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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.

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.

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 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.

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.