Abby consumes only apples. In year 1, 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.
a. 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?
b. Compute Abby’s nominal spending on apples in each year. How does it change from year 1 to year 2?
c. 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?
d. Defining the implicit price deflator as nominal spending divided by real spending, compute the deflator for each year. How does the deflator change from year 1 to year 2?
e. Suppose that Abby is equally happy eating red or green apples. How much has the true cost of living increased for Abby? Compare this answer to your answers to parts (a) and (d). What does this example tell you about Laspeyres and Paasche price indices?