Question

Please find in the figure (Source: The World Bank) the GDP of Italy in the last 17 years. The pale line represents the Nominal GDP of Italy measured at current prices (GDP in year X is computed using prices of year X), whereas the dark line shows GDP measured at 2010 prices (base year). 1. a. b. c. Provide a general comment on the picture, pointing out the most relevant economic aspects. [3p] What can we say about inflation in Italy in the last 17 years? [2p] What does the figure suggest about the inflation rate in 2010? [2p] ITALY (NOMINAL VS REAL GDP) GDP Italy (2010 prices, in million )GDP Italy (Current Prices, in million ) 1.700.000,0 1.600.000,0 1.500.000,0 1.400.000,0 1.300.000,0 1.200.000,0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Answer 1

Solution:

The pale line represents the nominal GDP of Italy, while the dark line represents the GDP of Italy measured at base year, 2010 prices. This means that the dark line is adjusted for inflation and hence, represents the real GDP of Italy (as any change in GDP due to price change has been taken care of in this case)

a) From the picture, we can see pale line starts from a very low point as compared to dark line, suggesting that compared to base year, 2010, the prices in 2000 were very low. Clearly, price level has risen over time. Further, price is not only rising, it is rising at increasing rate (that is inflation exists or is positive). This is evident from the fact that nominal GDP (pale line) is increasing at a much faster rate than the real GDP (dark line). This means that over time, GDP has increased (till year 2007) in real terms, but there has also been inflation and that is why nominal GDP has a higher growth rate.

Mathematically, growth rate of real GDP = growth rate of nominal GDP - inflation rate

Or inflation rate = growth rate of nominal GDP - growth rate of real GDP

With 0 < growth rate of real GDP < growth rate of nominal GDP, inflation rate is positive.

From year 2008-09, both real and nominal GDP fall sharply, and also notice that after the base year, there is again a fall in GDP of both measures. In both the cases, decline in real GDP is much higher, suggesting that price level must have risen, but fall in real GDP is much stronger.

b) Our answer in part (a) partially carries answer to this question. We have already seen how the real GDP and nominal GDP of Italy have been acting in the last 17 years. Using that, we can comment on inflation as follows:

The declining distance between real and nominal GDP curves before the base year, and further expanding distance between two after the base year (or simply after the intersection of the two curves) suggests that the inflation has remained positive over time (that is price levels have been rising at increasing rate). The explanations behind this follows from part (a) itself. Further, for the years where both GDP has fallen have also been considered in above part, and proved that inflation has been positive.

For year 2007-08, real GDP has fallen, however nominal GDP has risen, meaning prices have increased considerably in that year (to surpass the lowering real GDP, such that nominal GDP is still increasing).

Overall, for all the years, we can say there has been inflation in last 17 years in Italy.

c) 2010 is the base year, that is the prices of year 2010 have been considered to compare and comment on inflation in rest years. Since, 2010 itself is the benchmark for inflation measure, we cannot comment on inflation rate in 2010, as for that we'll require to use some other year as the base year and then the comparison can be made in similar manner. This graph does not serve that purpose, as it uses 2010 as the base year.

This can also be noted mathematically, simply using the formula for inflation rate. Since for 2010, consumer price index (CPI) in current year is same as that of base year, it will give answer as 0% inflation rate, which is misleading with 2010 as the base year.