Economic Growth, Unemployment and Inflation: Question 2

Worked solution

Part (a): Calculating real GDP

Real GDP strips out the effect of rising prices by dividing nominal GDP by the price index and multiplying by 100:

$\text{Real GDP} = \frac{\text{Nominal GDP}}{\text{Price index}} \times 100$

Year 1: $\frac{300.0}{100} \times 100 = 300.0$

Year 2: $\frac{349.8}{106} \times 100 = 330.0$

Year 3: $\frac{348.48}{110} \times 100 = 316.8$

So real GDP is $300.0 billion (Year 1), $330.0 billion (Year 2) and $316.8 billion (Year 3).

Part (b): Real GDP growth rates

Percentage change uses the earlier year’s real GDP as the base:

$\%\Delta \text{Real GDP}_{1\to2} = \frac{330.0 - 300.0}{300.0}\times100 = \frac{30.0}{300.0}\times100 = +10\%$

$\%\Delta \text{Real GDP}_{2\to3} = \frac{316.8 - 330.0}{330.0}\times100 = \frac{-13.2}{330.0}\times100 = -4\%$

So real GDP grew by $+10\%$ from Year 1 to Year 2, then fell by $4\%$ ($-4\%$ growth) from Year 2 to Year 3.

Part (c): A cause of the growth in real GDP

Economic growth (an increase in real GDP) is caused by increases in the quantity or quality of an economy’s factors of production. One possible cause of the $+10\%$ increase in Velmora’s real GDP between Year 1 and Year 2 is increased investment in capital, for example, firms buying new machinery or equipment. More investment raises the quantity of capital available to firms; more (and better) capital increases Velmora’s capacity to produce goods and services, so more real output can actually be produced and real GDP rises.

Other causes would explain the increase equally well, provided the mechanism linking them to higher real output is explained: a growing labour force (more workers producing more output between them), or improvements in technology or productivity (existing workers and capital producing more output per hour worked). Any one clearly-explained cause of this kind is creditworthy. Simply naming a cause without explaining why it raises real GDP would not earn full marks.

Part (d): A benefit and a cost of economic growth

Benefit: Because real GDP has risen, Velmora is producing more real output than before. Provided the population does not grow at the same rate, this means average real income and living standards rise. Households have access to more goods and services, and the government has a larger real tax base to fund public services such as healthcare and education.

Cost: Growth is not costless. Producing more output uses more resources, which can cause environmental damage, for example more pollution, or faster depletion of scarce natural resources. Growth can also add to inflationary pressure: notice that Velmora’s own GDP price index rose every year shown in the table (from 100 to 106 to 110), consistent with rising demand for output putting upward pressure on the general price level.

Final answers

• (a) Real GDP: Year 1 $=$ $300.0bn, Year 2 $=$ $330.0bn, Year 3 $=$ $316.8bn
• (b) Real GDP growth: Year 1–2 $=$ $+10\%$, Year 2–3 $=$ $-4\%$
• (c) One possible cause: increased investment in capital (or a growing labour force / improved technology), which raises the quantity or quality of factors of production and so raises real output
• (d) Benefit: higher average real income and living standards. Cost: environmental damage and/or inflationary pressure, consistent with the rising price index in the table