1. 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 at $0.40 each and 800,000 servings of onion rings at $0.60 each. From 2013 to 2014, the price of french fries rose by 25% and the servings sold fell by 10%; the price of onion rings fell by 15% and the servings sold rose by 5%.
Calculate nominal GDP in 2013 and 2014. Calculate real GDP in 2014 using 2013 prices.
In 2013 nominal GDP was (1,000,000 × $0.40) + (800,000 × $0.60) = $400,000 + $480,000 = $880,000. A 25% rise in the price of french fries from 2013 to 2014 means that the 2014 price of french fries was 1.25 × $0.40 = $0.50. A 10% fall in servings means that 1,000,000 × 0.9 = 900,000 servings were sold in 2014. As a result, the total value of sales of french fries in 2014 was 900,000 × $0.50 = $450,000. A 15% fall in the price of onion rings from 2013 to 2014 means that the 2014 price of onion rings was 0.85 × $0.60 = $0.51. A 5% rise in servings sold means that 800,000 × 1.05 = 840,000 servings were sold in 2014. As a result, the total value of sales of onion rings in 2014 was 840,000 × $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 french fries × $0.40) + (840,000 onion rings × $0.60) = $360,000 + $504,000 = $864,000.
Why would an assessment of growth using nominal GDP be misguided?
The change in nominal GDP from 2013 to 2014 was (($878,400 − $880,000)/$880,000) × 100 = −0.18%, a decline. But a comparison using real GDP shows a decline of (($864,000 − $880,000)/$880,000) × 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.