Question

1 TASK

A government survey determines that typical family expenditures each month in the year designated as the base year are as follows:

15 chickens, each $5

Rent, monthly $300

Gasoline and car maintenance, $50

Phone service, basic service $30

In the year following the base year, the survey finds: chickens rose to $7 each, apartment rent is $450; gasoline and maintenance rose to $90 and phone service has remained at $30.

1. Find the CPI in the subsequent year and the rate of inflation between the years. Show your work
2. The family’s nominal income rose by 40% between the base year and the subsequent year. Are they worse off or better off in terms of what their income is able to buy?

2 TASK

Manufacturing autos may occur in three stages; iron ore is mined and transformed into steel. The steel is then used in automobiles sold to the public. Cleveland Ore mines the ore, assume it takes $1 million in revenue with costless inputs. Ore EO Company transforms the raw iron into the steel with a value of $3 million. Finally Vespa sells the autos to final users, its revenues are $5 million.

1. Complete the table below to calculate the value added by each firm.

Firm	Revenues	Cost of purchased Inputs	Value added
Cleveland Ore
Ore EO
Vespa

1. Suppose all these transactions took place in 2018. By how much did GDP increase because of these transactions?
2. Suppose that Cleveland Ore mined the ore in June 2017 and sold it to Ore EO in October 2017. Ore EO then sold the steel to Vespa in December 2017. Vespa sells the autos in January of 2018. By how much did GDP increase in 2017 and 2018 as a result of these transactions?

Answer 1

Expenditure on final goods and services in the base year= (15*5*12 + 300*12 + 50*12 + 30*12)$ = 5460$

Expenditure on final goods and services in the following year= (15*7*12 + 450*12 + 90*12 + 30*12)$ = 8100$

CPI in the subsequent year= (Expenditure on final goods and services in the final year/ Expenditure on goods and services in the base year) *100= (8100/5460)*100= 148.351

Rate of Inflation = [(8100-5460)/5460]*100= 48.351%

Although the nominal income of the family rose by 40% they will still be worse off because the inflation rate (48.351%) is greater than the rise in nominal income. We know that real income = nominal income/ inflation rate so despite their rise in nominal income due to higher inflation rate their real income falls and thus they are worse off in terms of what their income is able to buy that is in terms of their real income.