Ch 18

Question 1

The Consumer Price Index (CPI)

Answer 1

is a measure of the cost of living during a particular period

Question 2

The CPI measures

Answer 2

The cost of a standard basket of goods and services in a given year
relative to the cost of the same basket of goods and services in the base year

Question 3

2010 is the base year for the CPI

Answer 3

Base year changes periodically

Question 4

Calculating the CPI

Answer 4

CPI is the ratio of the cost of the base year basket of goods in the current year to the cost in the base year
Base year cost $940
2015 cost $1,175

CPI = 1175 / 940 = 1.25

Question 5

A price index

Answer 5

measures the average price of a given quantity of goods and services relative to the price of the same goods and services in a base year
CPI measures the change in consumer prices

Question 6

Other indices

Answer 6

Producer price index

Import / export price index

Question 7

The rate of inflation

Answer 7

is the annual percentage change in the price level

Question 8

The Great Depression

Answer 8

Period of falling output and prices
When inflation rates are
negative there is deflation

Question 9

Deflation represents

Answer 9

a situation in which the prices of most goods and services are falling over time so that inflation is negative

Question 10

A nominal quantity

Answer 10

is measured in terms of its current dollar value

Question 11

A real quantity

Answer 11

is measured in physical terms

Quantities of goods and services

Question 12

To compare values over time, use real quantities

Answer 12

Deflating a nominal quantity converts it to a real quantity

Divide a nominal quantity by its price index to express the quantity in real terms

Question 13

Indexing

Answer 13

increases a nominal quantity each period by the percentage increase in a specified price index
Indexing prevents the purchasing power of the nominal quantity from being eroded by inflation

Question 14

Indexing automatically adjusts

Answer 14

certain values, such as Social Security payments, by the amount of inflation
If prices increase 3% in a given year, the Social Security recipients receive 3% more
Indexing is sometimes included in labor contracts

Question 15

Adjusting for Inflation

Answer 15

An indexed labor contract
First year wage is $12 per hour
Real wages rise by 2% per year for next 2 years
Relevant price index is 1.00 in first year, 1.05 in the second, and 1.10 in the third

Question 16

Minimum Wage

Answer 16

• Because the minimum wage is not indexed to inflation, its purchasing power falls as prices rise
• Governments must raise the nominal minimum wage periodically to keep the real value of the minimum wage from eroding

Question 17

CPI and Inflation

Answer 17

CPI and other indexes influence policy decisions and wage increases
Inflation may be overstated
Unnecessarily increases government spending
Underestimates increase in the standard of living
Suppose CPI indicates 3% inflation when cost of living actually increases 2%
Nominal income increases 3%, Real income increases 1% (3% nominal income-2% inflation)

Question 18

CPI uses a fixed basket of goods and services

Answer 18

• When the price of a good increases, consumers buy less and substitute other goods
• Failing to account for substitution overstates inflation

Question 19

The price level

Answer 19

is a measure of the overall level of prices at a particular point in time
Measured by a price index such as the CPI

Question 20

The relative price

Answer 20

of a specific good is a comparison of its price to the prices of other goods and services

Question 21

Example

Answer 21

Suppose we have a one-time doubling of the gas price
Overall price level and inflation increase by a small amount
The increase in the relative price of gasoline is large

Question 22

Relative Prices

Answer 22

Relative prices can change markedly without corresponding changes in inflation

Question 23

Prices transmit information about

Answer 23

The cost of production and

The value buyers place on buying an additional unit

Question 24

Inflation creates static in the communication

Answer 24

Buyers and sellers can’t easily tell whether
The relative price of this good is increasing OR
Inflation is increasing the price of this good and all others
Deciding these issues requires market participants gather information – at a cost
Response to changing prices is tentative and slow

Question 25

Income taxes have been indexed to avoid bracket creep

Answer 25

Bracket creep occurs when a household is moved into a higher tax bracket due to increases in nominal but not real income Higher tax brackets have a higher tax rate

Question 26

Indexing income taxes matches tax rates to the real income level

Answer 26

Suppose the tax rate on $50,000 is 25% in 2000 CPI is 1 for 2000, 1.25 for 2005 Nominal income of $62,500 is taxed 25% in 2005

Question 27

Distortions Caused by Taxes

Answer 27

Not all taxes are indexed

Question 28

Capital depreciation allowance encourages purchase of capital goods

Answer 28

Allows firms to deduct a share of the purchase price as a business expense Machine cost is $1,000 and its useful life is 10 years Capital depreciation allowance of $100 per year $100 in year 1 is worth more than $100 in year 10 because of inflation

Question 29

Taxes that are not indexed distort the tax incentives for people to work, save, and invest

Answer 29

Lower savings and investment means lower economic growth – a real cost of inflation

Question 30

If there is no inflation, cash holds its value over time

Answer 30

Some cash will be held for convenience

Question 31

Inflation Increases the Cost of Cash

Answer 31

When inflation is high, cash loses value over time

Question 32

Manage cash balances to limit losses

Answer 32

More frequent, smaller withdrawals cost consumers and businesses time, travel – a real cost of inflation Banks process more transactions, increasing costs – another real cost of inflation Costs of managing cash holding are called "shoe leather" costs, referring to the cost of frequent trips to the bank

Question 33

Hyperinflation

Answer 33

is an extremely high rate of inflation There is no official threshold above which inflation becomes hyperinflation. However, episodes when the monthly inflation rate is greater than 50 percent are considered.

Question 34

Causes of hyperinflation

Answer 34

Extreme rapid growth in the supply of “paper” money. large quantities of money issued by the government to pay for a large stream of government expenditures. Self-perpetuating: a cycle of inflation and money growth

Question 35

Another important aspect of inflation is its close relationship to other key macroeconomic variables

Answer 35

Economists have long realized that during periods of high inflation, interest rates tend to be high as well

Question 36

Suppose that there are two neighboring countries, Alpha and Beta

Answer 36

In Alpha: currency is alphan Inflation rate is zero and is expected to stay zero In Beta: currency is betan Inflation rate is 10 percent and is expected to remain at that level

Question 37

Inflation and Interest Rates

Answer 37

Unanticipated inflation helps borrowers and hurts lenders

Question 38

The real interest rate

Answer 38

is the annual percentage increase in the purchasing power of financial assets Real interest rate = nominal interest rate – inflation r = i - 3.14

Question 39

The nominal interest rate

Answer 39

is the annual percentage increase in the dollar value of an asset Nominal interest rates are the most commonly stated rates

Question 40

Fisher effect

Answer 40

is the tendency for nominal interest rates to be high when inflation is high and low when inflation is low