Check Your Understanding

1. Question

   Assume there are only two goods in the economy, french fries and onion rings. In 2013, 1,000,000 servings of french fries were sold for $0.40 each and 800,000 servings of onion rings were sold for $0.60 each. From 2013 to 2014, the price of french fries rose to $0.50 and the servings sold fell to 900,000; the price of onion rings fell to $0.51 and the servings sold rose to 840,000.

   1. Calculate nominal GDP in 2013 and 2014. Calculate real GDP in 2014 using 2013 prices.

      In 2013 nominal GDP was (1,000,000 X $0.40) + (800,000 X $0.60) = $400,000 + $480,000 = $880,000. The total value of sales of french fries in 2014 was 900,000 X $0.50 = $450,000. The total value of sales of onion rings in 2014 was 840,000 X $0.51 = $428,400. Nominal GDP in 2014 was $450,000 + $428,400 = $878,400. To find real GDP in 2014, we must calculate the value of sales in 2014 using 2013 prices: (900,000 x $0.40) + (840,000 x $0.60) = $360,000 + $504,000 = $864,000.

   2. Why would an assessment of growth using nominal GDP be misguided?

      A comparison of nominal GDP in 2013 to nominal GDP in 2014 shows a decline of (($880,000 - $878,400)/$880,000) x 100 = 0.18%. But a comparison using real GDP shows a decline of (($880,000 - $864,000)/$880,000) x 100 = 1.8%. That is, a calculation based on real GDP shows a drop 10 times larger (1.8%) than a calculation based on nominal GDP (0.18%): in this case, the calculation based on nominal GDP underestimates the true magnitude of the change because it incorporates both quantity changes and price changes.

2. Question

   Indicate the effect of each of the following on real GDP:

   1. Chevrolet increases its production of Corvettes.

      Real GDP increases as the result of increased output.

   2. Consumer expenditures increase as a result of inflation.

      There is no change in real GDP; infl ation only affects nominal GDP.

   3. $50 billion is spent on hurricane cleanup.

      Real GDP increases as a result of the new spending.

   4. Citizens spend 10,000 hours as neighborhood watch volunteers.

      There is no change in real GDP, which does not capture volunteer work.