Chapter 12: Inflation & Money

Question 1

what is inflation

Answer 1

• a generalized rise in the overall level of prices
• a rise in the cost of living
• a decline in the purchasing power of money

Question 2

what is the Consumer Price Index (CPI)

Answer 2

it is a measure of the average prices people pay overt time for the goods and services they buy in their everyday lives

this index tracks the average prices consumers pay over time for a representative basket

Question 3

what is inflation rate

Answer 3

it is how much the CPI changes on average.

It is the percent change in the price of a fixed basket of goods

Question 4

how do you calculate inflation rate

Answer 4

inflation rate = (price level this year - price level last year) / price level last year * 100

or

inflation rate = 100 * (change in price level CPI/ starting price level CPI)

you can calculate inflation rate using any price index, including the GDP deflator

Question 5

say inflation was 2%,

it can be interpreted 3 ways. what are they

Answer 5

• prices are 2% higher on avg
• the cost of living is 2% higher
• a dollar buys 2% less

Question 6

what are the 4 steps in constructing the consumer price index and measuring inflation

Answer 6

1. find out what people buy (via surveys and construct a basket)
2. collect prices from the stores where people do their shopping
3. Tally up the prices of the basket
   4.calculate inflation rate as the percentage change in the price of the basket

Question 7

true or false: the CPI puts equal weights on the products, regardless of how much of one you purchase

Answer 7

false: CPI puts more weight on products you buy more of.

ex. if you buy 5x as much coffee as tea then the basket included 5x as much coffee than tea

Question 8

define deflation

Answer 8

generalized decrease in the overall price level

Question 9

what problem comes from deflation

Answer 9

people will stop buying

Question 10

what is substitution bias and how does it affect CPI measures

Answer 10

it is the overstating of inflation due to people substituting their basket of goods for goods whose price rise by less.

Question 11

The CPI has sub-indices

such as
- all items
- all items except food and energy (“core” CPI / “core” inflation)
- Median price change (rather than average)

define them

Answer 11

all items: it is a broad measure which best captures how inflation is experienced by Canadian households.

core CPI: when you set aside temporary fluctuations and reveal the underlying inflation trend. food and energy markets are volatile, leaving them out may give a clearer picture into trends

Median price change: it tracks the 50th percentile of price changes withing the CPI basket. Median is less sensitive to outliers, leaving them out may reduce the effects of the substitution bias.

Question 12

what is indexation

Answer 12

it automatically adjusts policies/wages/taxes etc to keep up with rising cost of living

Question 13

what is the producer price index (PPI)

Answer 13

measures the price of inputs in the production process

Question 14

what is the GDP deflator

Answer 14

an alternative price index that represents changes in the market price of a country’s output

like CPI is is always 100 in the base year

can be used to convert nominal GDP into Real GDP

Question 15

how do you calculate the GDP deflator

Answer 15

GDP deflator = nominal GDP / Real GDP * 100

Question 16

how do you use the CPI to convert dollar amounts in year s to its equivalent in year t

Answer 16

value in year t = value in year s * CPI(t) / CPI(s)

Question 17

what is a nominal variable

Answer 17

it is measured in dollars whose values may fluctuate, either due to changing quantities or inflation

Question 18

what is a real variable

Answer 18

a variable that has been adjusted for the influence of inflation

Question 19

what is nominal interest rate

Answer 19

interest rate without a correction for the effects of inflation

Question 20

what is real interest rate

Answer 20

measures interest rate in terms of changes in purchasing power

Question 21

what is money illusion

Answer 21

the mistaken tendency to focus on nominal dollar amounts (leads you to be fooled by inflation)

Question 22

what are the 3 consequences of money illusion

Answer 22

1. can distort decision
2. can lead to mis pricing
3. creates nominal wage rigidity

Question 23

what are the 3 functions of money

Answer 23

1. is a medium of exchange
2. is a unit of account
3. money is a store of value

Question 24

how does inflation affect the functions of money

Answer 24

high, unstable, unpredictable inflation undermines the benefits of money

Question 25

what is hyperinflation

Answer 25

extremely high rates of inflation. it erodes the 3 functions of money

Question 26

what is the costs of expected inflation

Answer 26

1. menu costs for sellers (costs of adjusting prices) 2. shoe-leather costs for buyers (people hold less money, and tend to keep money in assets that maintain value better), it is the costs taken to avoid holding money

Question 27

what is the costs of unexpected inflations

Answer 27

1. confuses the signals prices send 2. inflation redistributes (inflation higher than normal is good for borrowers and bad for lenders, and vice versa) (increased risk)

Question 28

what is the inflation fallacy

Answer 28

the mistaken belief that inflation destroys purchasing power, wages rise too

Question 29

how do you calculate real interest rate

Answer 29

real interest rate = nominal interest rate - inflation rate

Question 30

what are 3 reasons inflation overstates the cost of living

Answer 30

- unmeasures quality improvments - new products - substitution bias

Question 31

how do you calculate CPI

Answer 31

CPI = 100 * (cost of basket in other year / cost of basket in base year) note: CPI is unitless, not a percent or anything else

Question 32

what are the 3 steps to calculate the CPI

Answer 32

1. choose a market basket and base year 2. calculate the cost of the basket each year 3. apply the CPI formula on each year against the base year

Question 33

true or false: the CPI is always 100 in the base year

Answer 33

true

Question 34

you can convert nominal variables into real variables by applying the inflation adjustment formulas you can find 1. Today's dollars 2. Percent change in real value 3. real interest rate what are the formulas for the above 3

Answer 34

1. Today's Dollar = Another time's dollar * (price level today / price level in another time) 2. Percent change in real value = percent change in nominal value - percent change in prices 3. Real interest rate = nominal interest rate - inflation rate

Question 35

true or false: inflation rate does not depend on our choice of base year

Answer 35

true, inflation is the same since it is measuring the difference

Question 36

define the quantity theory of money as a theory of the cause of inflation

Answer 36

the theory states that: inflation is caused by the supply of money is growing faster than the supply of things to buy inflation rate = money growth rate - GDP growth rate this theory is useful for predicting inflation over long time periods, not useful for predicting short time periods