Question

Suppose that in the base year, GNP $$=\mathrm{\$}1000$$ billion. Since the base year, money GNP has increased $$\mathrm{\$}500$$ billion while real GNP has increased $$\mathrm{\$}250$$ billion. What is the current price index? In which year is society better off? Why?

Short answer

The current price index (GNP deflator) is $120$, and society is better off in the current year due to the increase in real GNP from $1000$ billion in the base year to $1250$ billion in the current year, indicating an improvement in living standards compared to the base year.

Step-by-step solution

Calculate Nominal GNP in the Current Year

The nominal GNP in the base year is given as $1000$ billion, and money GNP has increased by $500$ billion. To find the nominal GNP in the current year, we'll add the increase to the base year nominal GNP: Nominal GNP (current year) = Base year nominal GNP + Increase in money GNP Nominal GNP (current year) = $1000$ billion + $500$ billion = $1500$ billion

Calculate Real GNP in the Current Year

Real GNP has increased by $250$ billion from the base year. To find the real GNP in the current year, we'll add this increase to the base year GNP: Real GNP (current year) = Base year GNP + Increase in real GNP Real GNP (current year) = $1000$ billion + $250$ billion = $1250$ billion

Calculate the Price Index (GNP Deflator)

The price index or GNP deflator is found by dividing the nominal GNP by the real GNP and multiplying the result by $100$. We'll use the values we found in the previous two steps to calculate the price index: Price Index (GNP Deflator) = (Nominal GNP / Real GNP) * 100 Price Index (GNP Deflator) = ($1500$ billion / $1250$ billion) * 100 = $1.2 * 100 = 120

Determine In Which Year Society is Better Off

Living standards can be reflected through the real GNP because it is adjusted for inflation. As the real GNP increases, the living standard of society generally improves. In this case, the real GNP of the base year is $1000$ billion, and the real GNP of the current year is $1250$ billion. Since the real GNP is higher in the current year, society is better off in the current year. In conclusion, the current price index (GNP deflator) is $120$, and society is better off in the current year due to the increase in real GNP. This suggests an improvement in living standards compared to the base year.

Key concepts

Nominal GNP

Nominal GNP, or Nominal Gross National Product, is the total value of all final goods and services produced by a country in a given year, measured using current prices. It is a way to measure the economic performance of a country without adjusting for inflation.

When calculating nominal GNP, it includes the effects of price changes over time. For example, if the price of goods and services increases, the nominal GNP will also rise, even if the actual amount of goods and services produced has not changed.
An increase in money GNP, like the additional $500 billion in the exercise, reflects changes in both the quantity of goods and services produced and the prices at which they are sold.

• Nominal GNP provides a snapshot of economic activity at current market prices.
• It does not consider inflation, which can lead to overestimation of growth if prices increase significantly.

To fully understand the economic well-being of a country, it is necessary to consider not just nominal GNP, but also the changes in price levels through inflation indicators.

Real GNP

Real GNP, or Real Gross National Product, adjusts for changes in the price level or inflation to reflect the actual quantity of goods and services produced. It is a more accurate measure when determining the real growth of an economy.

While nominal GNP measures values at current prices, real GNP measures them at constant prices, usually from a base year. This allows economists to make more meaningful comparisons over time by eliminating the effects of inflation.
In the exercise, the real GNP increased by $250 billion, showcasing a true increase in production.

• Real GNP shows the true economic growth by accounting for inflation, offering a clearer picture of economic health.
• An increase in real GNP implies that more goods and services are being produced, thus improving the standard of living.

Using real GNP is essential for evaluating progress in terms of increased productivity and efficiency within an economy.

Price Index

The price index, specifically the GNP deflator in this context, measures the change in prices of goods and services over time, which is used to convert nominal GNP to real GNP. This index compares the current price level to that of a base year.

The GNP deflator provides insight into how much prices have increased or decreased, allowing analysts to strip out the effects of inflation from the GNP. In our example, it can be calculated as follows:

• Find the ratio of nominal GNP to real GNP.
• Multiply this ratio by 100 to express it as an index number.

The computed price index in the exercise is 120, indicating an increase in the overall price level since the base year.

• A price index greater than 100 signifies that prices have increased since the base year.
• This helps in understanding inflation rates and their impact on economic growth measures.

The GNP deflator is particularly important for economic policymaking, as it helps determine the real progress of an economy by providing a measure of price stability.