Question 2 (34 marks) a) ‘Most countries import substantial amounts of goods and

Question

Question 2 (34 marks)
a) ‘Most countries import substantial amounts of goods and services from other countries.’

‘A nation can enjoy a higher living standard only if it can produce a large quantity of good and services itself.’

How can these two statements be reconciled?
(13 marks)

b) Suppose the people of an economy consume only 2 goods, namely bread and shirts. The production of goods and services in this economy consists of 70 units of food, 200 units of clothing and 50 units of machinery for production for both years.

Bread Shirts Machinery for production
Year 1 price $10 $5 $20
Year 2 price $15 $10 $25
i Find the nominal GDP for the current year and base year. Show
all your workings. (7 marks)

ii What is the percentage increase in the CPI? Show all your
workings. (7 marks)

iii What is the percentage increase in the GDP deflator? Show all
your workings. (7 marks)

Explanation / Answer

(a)

High volume of imports can be reconciled with high volume of domestic production using the logic of comparative advantage.

A country should specialize in and export only those goods which it can produce ata a lower opportunity cost compared to another country. Also, a country should specialize in those goods which utilize its abundant resources extensively. So, a land-abundant country should benefit from trade if it specializes in agricultural goods and exports them, and imports capital intensive goods. Therefore, it can domestically produce large volume of agricultural goods and after meeting domestic demand, can export the surplus production.

(b)

GDP measures only the final value of output produced, not the resources or factors required to produce the output. So Machines price/quantity will not be considered.

(i)

Nominal GDP, year 1 = $10 x 70 + $5 x 200 = $1,700

Nominal GDP, year 2 = $15 x 70 + $10 x 200 = $3,050

(ii)

Change in CPI = $3,050 / $1,700 x 100 = 179.41

(iii)

Since quantity consumed is the same for both years, Real and nominal GDP are the same in both years.

GDP Deflator = Nominal GDP / Real GDP x 100

Since in both years, Nominal GDP = Real GDP, the GDP Deflator is 100 in each year.

% increase in GDP deflator is therefore 0.

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