Question

Suppose that this year’s nominal GDP is \(16 trillion. To account for the effects of inflation, we construct a price-level index in which an index value of 100 represents the price level 5 years ago. Using that index, we find that this year’s real GDP is \)15 trillion. Given those numbers, we can conclude that the current value of the index is:

a. higher than 100.

b. lower than 100.

c. still 100.

Short answer

Option (a):higher than 100

Step-by-step solution

Meaning of nominal and real GDP

The nominal GDP shows the unadjusted value of the output produced within the country, and real GDP shows the inflation-adjusted value of output produced within the country.

The price index is used to convert nominal GDP to real GDP and is given by:

\({\rm{Price index = }}\frac{{{\rm{Nominal GDP}}}}{{{\rm{Real GDP}}}}{\rm{ \times 100}}\)

Explanation for choosing option (a)

If the nominal GDP in the current year is $16 trillion and the real GDP is $15 trillion, then Price Index will be 106.66, as calculated below.

\(\begin{aligned}{c}{\rm{Price index = }}\frac{{{\rm{Nominal GDP}}}}{{{\rm{Real GDP}}}}{\rm{ \times 100}}\\ = \frac{{{\rm{16 trillion}}}}{{{\rm{15 trillion}}}}{\rm{ \times 100}}\\{\rm{ = 106}}{\rm{.66}}\end{aligned}\)

The price index is 106.66, which is higher than 100. Thus, option ‘a’ is correct.