Question

Abby consumes only apples. In year1, red apples cost $1 each, green apples cost $2 each, and Abby buys 10 red apples. In year 2, red apples cost $2, green apples cost $1, and Abby buys 10 green apples.

1. Compute Abby’s nominal spending on apples in each year. How does it change from year 1 to year 2?
2. Compute a consumer price index for apples for each year. Assume that year 1 is the base year in which the consumer basket is fixed. How does your index change from year 1 to year 2?
3. Using year 1 as the base year, compute Abby’s real spending on apples in each year. How does it change from year 1 to year 2?

Answer 1

Step-by-step explanation:

1. Nominal spending is the total value of output produced or consumed each year.

Year 1 Abby buys 10 ×$1 = $10

Year 2 Abby buys 10 ×$1= $10

⇒ nominal spending= $10

2. Base year - year 1

Consumer price index is a measure of the average change over time in the prices paid by consumers for a market basket of consumer goods and services.

CPI= (prices of the most recent market basket in the particular year/ prices estimate of market basket in base year )x100

However, for multiple products we have to consider the weights of an item.

So, the formula will be:

CPI2= [(P2Red xQ1Red)+ (P2green x Q1green)]/[(P1Red xQ1Red)+ (P1grn x Q1grn)]

CPI2=[ (2 x 10) + (1x0)]/ [(1x10)+(2x0)]

CPI2=20/10=2

Meaning that prices have incresed × 2

3. Real spending is the amount spent in the current year but caliculted at the base year price.

Base year prices:

Red $1

Green $2

Real spending in year 1: (P1red*Q1red) + (P1green*Q1green)

=$1x10 + 0 = $10

Real spending in year 2= (P1redQ2red) + (P1greenQ2green)

= (1x 0) +(2 x 10) = $20

Real spending has increased from $10 to $20