EC1101E 1 October 2021

Macro Problem Set 1 solutions

Q1
a. No solutions are provided. Refer to your tutorial discussion.
b. The -42.9 percent growth rate is an annualized, seasonally-adjusted, quarter-on-quarter
growth rate. Quarter on quarter means the growth rate is that of RGDP 2Q2020 over
RGDP 1Q2020. Since there are seasonal factors in quarters, the data is seasonally-adjusted.
Finally the growth rate is extrapolated to a full year (annualized). The 13.2 percent
number is a year-on-year growth rate, i.e. that of RGDP 2Q2020 over RGDP2Q2019.
Enrichment: this 2003 SingStat Newsletter piece explains the difference between the two:
Neo, P. C. (2003). Quarterly Growth Rates. Statistics Singapore (PDF).

Q2
a. Harford uses the term “consumption of shelter” to denote the value of living in a home
for a year. GDP should include such values for both tenants (measured by rent) and
people who live in their own homes (estimated). Otherwise, measured GDP can be
mistakenly changed if people switch from being owner-occupiers to renters, or from
renters to owner-occupiers.
b. A reason to include the value of home production in GDP is that it can readily be
estimated, since there are market prices for domestic help. A reason not to include it is
that the amount of unpaid home production is not well-measured, since there is no
transactions data.
c. The building up of physical capital assets (such as buildings) is included in GDP but the
wearing down (depreciation) or outright destruction of the same assets is not subtracted
from GDP. The environment can also be seen as an asset whose destruction is not
subtracted from GDP, but arguably should be.

Q3
a. The $5,000 cash grant is a transfer payment and does not in itself affect GDP. When
Annina spends the grant on her child’s extra-curricular activities, consumption rises.
b. The $10,000 that Benjamin pays for shares in DBS Bank stock is not included in GDP. The
stock shares are financial assets, being claims to a share of ownership of DBS Bank. They
are neither goods nor services. However, the 1% commission is payment for a service,
and thus $100 is included in GDP as consumption.
c. Consumption rises by 2,000 x $50 = $100,000. Investment falls by 500 x $50 = $25,000 due
to the fall in textbook inventories. GDP rises by $75,000.
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d. Investment rises by $30 million, consisting of $10 million of tools and $20 million
addition to inventory of motors. GDP rises by just $10 million because the $20 million of
motors was imported.

Q4

Refer to the table below for the answers.

2015 2016 2017

(a) Nominal GDP ($’000) 1,240 1,790 2,670

(b) GDP at 2015 prices ($’000) 1,240 1,380 1,560

Growth rate N.A. 11.29% 13.04%

(c) GDP at 2016 prices ($’000) 1,620 1,790 2,020

Growth rate N.A. 10.49% 12.85%

(d) Growth rate, using previous

year prices ($’000) N.A. 11.29% 12.85%

112.85% x
GDP in chained (2015) dollars 111.29% x 1,240 111.29% x 1,240
($‘000)
1,240 = 1,380 = 1,557

Using the fixed-base method, the growth rates change when the base year is changed. The
2016 growth rate is 11.29% when 2015 is used as the base year but is 10.49% when 2016 is
used as the base year.

Using the chain-linking approach, each year’s growth rate is based on the previous year’s
prices. Thus, the growth rates do not change when the reference year is changed. The 2016
growth rate will remain as 11.29% even if the reference year is changed from 2015 to another
year.

Why have statistical agencies been moving from the fixed-base approach to the chain-linked
approach? One reason is seen in the calculations above. To have growth rates altered every
time the base year is changed is problematic, since it means one’s assessment of the
economy’s performance is changed.
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Base years must be changed periodically to reflect changes in economic structure. GDP is a
weighted average of quantities, with prices used for weights. In any period, the prices
reflect the economy’s structure. For example, clothing is relatively more important to the
economy in 2017 than in 2015. The fixed-base method fixes the weights to reflect the base
year’s economic structure. This may not be appropriate for times of major shifts in economic
structure. Thus, another reason to use the chain-linking approach is that it allows for shifts
in economic structure as real GDP growth is always computed based on prices that are just
one year removed.

Enrichment: “GDP at previous year’s prices” is not directly comparable over time. Instead,
real GDP in the chain-linked approach is found by doing additional computations. Refer to
the last line in the table “GDP in chained (2015) dollars”, which is the real GDP computed
using the chain-linking approach. The reference year is 2015, so its nominal GDP is set as its
real GDP. 2016’s real GDP is calculated as 112.72% x 2015 real GDP. 2017’s real GDP is
calculated as 114.20% of 2016’s real GDP, so it is 114.20% x 112.72% x 2015 real GDP. The
three years’ real GDP’s are thus chained together by the growth rates, hence the name
“chain-linking”.

Q5
a.

Cost of the CPI basket in 2017 = 10($20) + 10($15) = 350($).

Cost of the CPI basket in 2018 = 10($30) + 10($20) = 500($).

Since 2017 is the base year, CPI 2017 = 100, while CPI 2018 = 100 x $500/$350 = 142.9.

Thus, 2018 inflation rate = (142.9 – 100)/100 = 42.9% per year.

Note that the CPI is a weighted average of prices, with the quantities in the CPI basket
used as weights.

b.

Since 2018 is now the base year, CPI 2018 = 100, while CPI 2017 = 100 x $350/$500 = 70.

Thus, 2018 inflation rate = (100 – 70)/70 = 42.9% per year. The CPI inflation rate does not
change when the base year is altered.
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c.

As the price for shirts rose faster than price for meals in 2018, the typical household reduced
shirt purchases to 6 and increased meal purchases to 15. Thus, the cost of the actual basket in
2018 = 6($30) + 15($20) = $480.

The true percent rise in cost of living in 2018 is thus ($480 – $350)/$350 = 37.1% a year. The
CPI overestimates the rise in cost of living because the market basket is fixed. This is a
demonstration of the CPI’s substitution bias.

Q6
a. The nominal interest rate is $7,000/$100,000 = 7% per year.
b. The expected inflation rate is CPIJan2019 / CPIJan2018 – 1 = 0.02 = 2% (per year).
c. Using the Fisher Equation, expected real interest rate ≈ nominal interest rate – expected
inflation rate = 7% – 2% = 5% per year.
d. Expected interest in Jan 2018 dollars = ($107,000 x 100/102) – $100,000
= $4,902. Thus, expected real interest rate (actual) = $4,902/$100,000 = 4.9% per year. The
approximation is off by 0.1 percentage points.
e. Actual inflation rate = 5% per year. Hence, actual real interest rate (approximation) = 7%
– 5% = 2% per year.
f. Joash has gained purchasing power unexpectedly, while Meredith has lost purchasing
power unexpectedly.
g. They could have set the nominal interest rate to be 5% a year + annual CPI inflation rate.
That way, whether the actual inflation rate was 2% a year or 5% a year, the real interest
rate would stay at 5% a year. This is an example of an indexed loan.