Question

Assume there are only two goods in the economy, french fries and onion rings. In 2015, 1,000,000 servings of french fries were sold at $0.40eachand800,000servingsofonionringsat$0.60 each. From 2015 to 2016 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%.

1. Calculate nominal GDP in 2015 and 2016. Calculate real GDP in 2016 using 2015 prices.
2. Why would an assessment of growth using nominal GDP be misguided?

Short answer

1. Nominal GDP in 2015 was $880,000 and in 2016 was $878,400. Real GDP in 2016 with the base year 2015 was $864,000.
2. The growth assessment through nominal GDP is misguiding because it shows the output in 2016 has declined only by 0.18%, while in reality, the real output declined by 1.8%.

Step-by-step solution

 Step 1: Explanation for part (a)

The nominal GDP in a year is the summation of the final value of all the goods and services produced in the country in that year.

$\mathit{N}\mathit{o}\mathit{m}\mathit{i}\mathit{n}\mathit{a}\mathit{l}\mathbf{}\mathit{G}\mathit{D}\mathit{P}\mathbf{=}{\mathit{P}}_{\mathbf{f}}\mathbf{\times }{\mathit{Q}}_{\mathbf{f}}\mathbf{+}{\mathit{P}}_{\mathbf{O}}\mathbf{\times }{\mathit{Q}}_{\mathbf{O}}$

Nominal GDP in 2015:

$$\begin{gathered} NominalGD{P}_{2015}=\$0.4\times 1,000,000+\$0.6\times 800,000 \\ =\$400,000+\$480,000 \\ =\$880,000 \end{gathered}$$

Therefore, the nominal GDP in 2015 was $880,000

An increase in the price of French fries by 25% shifts the prices in 2016 to:

P_f = $0.4 x 1.25

= 0.5

Side by side, the supply of French fries fell by 100,000 % (10% of 1,000,000) in 2016, making the supply of French fries in 2016 equal to 900,000 (1,000,000-100,000).

Similarly, the price of onion rings in 2016 became $0.51 (= $0.6×0.85), and the supply quantity became 840,000 (= 800,000×1.05).

Thus, the nominal GDP in 2016 was:

$$\begin{gathered} NominalGD{P}_{2016}=\$0.5\times 900,000+\$0.51\times 840,000 \\ =\$450,000+\$428,400 \\ =\$878,400 \end{gathered}$$

Hence, the nominal GDP in 2016 was $878,400.

Real GDP in 2016 can be calculated using the price level in the base year 2015.

$$\begin{gathered} RealGD{P}_{2016}=\$0.4\times 900,000+\$0.6\times 840,000 \\ =\$360,000+\$504,000 \\ =\$864,000 \end{gathered}$$

Hence, the real GDP in 2016 was $864,000.

Explanation for part (b)

Change in the nominal GDP in 2016:

$$\begin{gathered} △NominalGD{P}_{2016}=\left(\frac{878,400-880,000}{880,000}\right)\times 100 \\ =-0.18 \end{gathered}$$

Thus the nominal GDP declined by 0.18% in 2016.

Change in the real GDP in 2016:

$$\begin{gathered} △RealGD{P}_{2016}=\left(\frac{864,000-880,000}{880,000}\right)\times 100 \\ =-0.18 \end{gathered}$$

It implies that the real GDP in 2016 declined by1.8% from 2015.

The assessment of growth using the nominal GDP shows a smaller decline in

output because of an overall increase in the price level.In reality, the real output has fallen more than the nominal GDP. Hence, the nominal GDP is misguiding.