ELS Chapter 4: Graphing Exercise 2 Answers

ELS Chapter 4: Graphing Exercise 2 Answers
Measuring GDP
1.	Double the prices and quantities produced for each of the goods in year 2. What happens to nominal and real GDP in year 2 and the growth rates of nominal and real GDP between the two years? Why is the growth rate of nominal GDP greater than the growth rate of real GDP between the two years?
	answer: When the prices and quantities are both doubled, the value of nominal GDP quadruples, while the value of real GDP doubles. The growth rate of nominal GDP between year 1 and year 2 is now 300%, while the growth rate of real GDP between the two years is now 100%. The reason why nominal GDP rises more than real GDP is because nominal GDP is calculated by multiplying current prices of goods and services by current quantities of goods and services, while real GDP is measured by multiplying current quantities by base-year (year 1) prices. That is, real GDP measures the value of economic activity as if the prices of goods and services did not change from the base year to the present. Since prices doubled from year 1 to year 2, measuring year 2's economic activity in base year prices (real GDP) leads to a value which is less than that obtained when measuring year 2's economic activity in current year (year 2) prices (nominal GDP). In this way, real GDP excludes the effects of price changes.
2.	Click the Reset button to restore the original values. Now double the quantities produced for each of the goods in year 2. What happens to nominal and real GDP in year 2 and the growth rates of nominal and real GDP between the two years?
	answer: Doubling the quantities of goods and services produced in year 2 leads to a doubling of both nominal and real GDP in year 2. That is, both real and nominal GDP have increased by 100% [100*(($700-$350)/$350)]. Since prices haven't changed, both nominal and real GDP yield the same value.
3.	Click the Reset button to restore the original values. Double the prices for each of the goods in year 2. What happens to nominal and real GDP in year 2 and the growth rates of nominal and real GDP between the two years?
	answer: In this case, doubling the prices of the goods and services in year 2, while keeping the quantities produced the same, leads to a doubling of nominal GDP, but has no effect on real GDP. Nominal GDP has grown by 100% but real GDP has not grown at all. That is because real production has not changed at all, while the value of that production, measured in current (year 2) prices, has doubled
4.	Based on your analysis in problem #3, which is the better measure of economic activity, real GDP or nominal GDP? Why?
	answer: GDP is the most commonly used measure of an economy's economic activity and is intended to measure how much an economy produces in a given period of time. However, based on the analysis of problem #3, we would conclude that nominal GDP does not always provide an accurate measure of production. When prices in an economy are changing, for example, the value of nominal GDP may change even when production hasn't, as in the previous exercise. Real GDP eliminates the effects of price changes by measuring the value of each year's output in constant (base-year) prices. This value changes only when actual production changes. As seen in the example above, price changes alone have no effect on the value of real GDP. Thus, we would conclude that real GDP provides a better measure of economic activity (production, spending, or value-added) than nominal GDP.