inflation

Question 1

what is economics?

Answer 1

economics is the study of the optimal use of limited resources in production and consumption

Question 2

what is inflation?

Answer 2

inflation is a generalized rise in the overall level of prices

also the decline in the purchasing power of money

Question 3

what is CPI?

Answer 3

the consumer price index (CPI) is an index that tracks the average price consumers pay over time for a representative basket of goods and services

Question 4

what is the formula for inflation rate?

Answer 4

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

Question 5

how is CPI constructed?

Answer 5

step one: find out what people typically buy

step two: collect prices from the stores where people do their shopping

step three: tally up the price of the basket of goods and services

step four: calculate the inflation rate based off the weighting

Question 6

what are some challenges with measurement of CPI?

Answer 6

• basket doesn’t apply to everyone
• government may not accurately collect price data
• quality improvements can hide price decreases (better products last longer)
• new products can make you better off, reducing your cost of living ( CPI only tracks the changing prices of existing goods - doesn’t account for the reduction in the cost of living due to the introduction of new products )
• you can save yourself money without sacrificing much (substitution bias)

Question 7

what is substitution bias?

Answer 7

the overstating of inflation occurs because people substitute towards goods whose prices rise by less

Question 8

what are the inflation measures (consumer) ?

Answer 8

1) CPI
2) personal consumption expenditure deflator
3) core inflation

Question 9

what is CPI used to measure?

Answer 9

measure the change in the cost of living

automatically adjusting wages, benefits, tax brackets, and the like to compensate for inflation is called indexation

Question 10

what is the personal consumption expenditure deflator used for?

Answer 10

used for monetary policy

the federal reserve sets its inflation target using the personal consumption expenditure (PCE) deflator

uses a slightly different basket of goods and services compared to the CPI

Question 11

what core inflation used for?

Answer 11

for forecasters who look for underlying trends in inflation

Question 12

what is core CPI?

Answer 12

everything except food and energy

Question 13

what is the formula for calculating CPI?

Answer 13

CPI (t) = (ptq0)/ (p0q0) x 100

quantity always stays the same

Question 14

what is the CPI for a base year?

Answer 14

always equal to 100

Question 15

what are the inflation measures for businesses?

Answer 15

1) Producer price index (PPI): a price index that tracks the price of inputs into the production process
2) GDP deflator: a price index that tracks the price of all goods and services produced domestically

Question 16

what is the formula for GDP deflator?

Answer 16

GDP deflator = nominal GDP/ real GDP x 100

Question 17

what is the inflation adjustment formula?

Answer 17

another time’s nominal dollars x (price level today / price level over time)

Question 18

what is a nominal variable?

Answer 18

a variable measured in dollars

Question 19

what is a real variable?

Answer 19

a variable that has been adjusted to account for inflation

Question 20

what is the nominal interest rate?

Answer 20

the stated interest rate without a correction for the effects of inflation

Question 21

what is the real interest rate?

Answer 21

the interest rate in terms of changes in your purchasing power

Question 22

how do you calculate real interest rate?

Answer 22

real rate = nominal rate - inflation rate

Question 23

what is money illusion?

Answer 23

the (mistaken) tendency to focus on nominal dollar amounts instead of inflation-adjusted amounts

Question 24

what are some issues that arise from money illusion?

Answer 24

1) distorting prices
2) leads to mispricing
3) creates nominal wage rigidity

Question 25

what is nominal wage rigidity?

Answer 25

the reluctance to cut nominal wages

Question 26

what is money?

Answer 26

any asset regularly used in transactions

Question 27

what are the three functions of money?

Answer 27

1) medium of exchange
2) unit of account
3) store of value

Question 28

what is hyperinflation?

Answer 28

hyperinflation is an extremely high rate of inflation

makes most aspects of life harder and erodes all the functions and value of money

Question 29

what are the costs of expected inflation?

Answer 29

1) Menu costs: (businesses have to change prices regularly, which is costly)
2) shoe leather costs: the costs incurred trying to avoid holding cash.
Arise because inflation undermines money’s function as a store of value

Question 30

what are costs of unexpected inflation?

Answer 30

1) confusing signals that the prices send
2) redistributing income - refers to loans

Question 31

what is the inflation fallacy?

Answer 31

the mistaken belief that inflation destroys purchasing power

The purchasing power stays the same because the wage also increases. Therefore, the opportunity cost of buying each item doesn’t change.

There is no change in the real variables