Inflation and Interest Rates

Question 1

What is the aggregate price level?

Answer 1

A measure of the overall level of prices in the economy.

Question 2

How do economists measure the aggregate price level?

Answer 2

By calculating the cost of purchasing a market basket of goods and services.

Question 3

What is a price index?

Answer 3

The ratio of the current cost of a market basket to the cost in a base year, multiplied by 100.

Question 4

What is the formula for calculating the price index in a given year?

Answer 4

Price index in a given year = (Cost of market basket in a given year) ÷ (Cost of market basket in base year) × 100.

Question 6

What does CPI stand for?

Answer 6

Consumer Price Index

The CPI is the most common measure of the aggregate price level.

Question 7

What is the primary use of the Consumer Price Index (CPI)?

Answer 7

To measure inflation

The CPI measures the cost of the market basket of a typical family.

Question 8

What is the Producer Price Index (PPI)?

Answer 8

An index for goods purchased by firms

The PPI measures the average change over time in the prices domestic producers receive for their output.

Question 9

What does the Producer Price Index (PPI) measure?

Answer 9

Average change in prices received by domestic producers

The PPI focuses on goods rather than consumer prices.

Question 10

What is the GDP deflator?

Answer 10

A measure of the price level calculated by the ratio of nominal GDP to real GDP

It provides another way to assess inflation.

Question 11

How is the GDP deflator calculated?

Answer 11

GDP Deflator = (Nominal GDP/Real GDP) × 100

This formula helps in understanding the changes in price level.

Question 13

What is inflation?

Answer 13

A rising aggregate price level

Question 14

What is deflation?

Answer 14

A falling aggregate price level

Question 15

How is the inflation rate defined?

Answer 15

The annual percentage change in the aggregate price level

Question 16

What does price stability mean?

Answer 16

The overall price level is changing only slowly

Question 18

What does the inflation rate do?

Answer 18

• gives the percentage increase in the overall level of prices per year.

Question 19

What does inflation do, and what doesn’t it do?

Answer 19

• it ruins the purchasing power of money income
• doesn’t necessarily make the people poorer if income rises as well as the prices

Question 20

What does the real income measure?

Answer 20

• Real Wage
• Real Income

Question 21

Real wage is…

Answer 21

the wage rate divided by the price level

Question 22

Real income is…

Answer 22

income divided by the price level

Question 23

What does Real Income give a measure of?

Answer 23

It provides a measure of the amount of goods and services that we can consume with a certain nominal income.

it is real income that matters for our welfare

Question 24

What happens to real wages and real income if wages and income rise in line with the price level?

Answer 24

they stay the same

Question 25

When does inflation tend to fall, and when does it tend to rise?

Answer 25

- it tends to fall when the economy is depressed and jobs are hard to find - it tends to rise when the economy is booming

Question 26

When are movements in inflation closely related to the business cycle?

Answer 26

- in the short run

Question 27

When is the overall level of prices mainly determined by changes in the money supply?

Answer 27

- in the long run

Question 28

Why is inflation problematic?

Answer 28

- it discourages people from holding onto cash (it loses value if the prices are rising)

Question 29

Why is deflation problematic?

Answer 29

- it can deepen a recession as holding onto cash is more attractive than investing in productive assets

Question 30

Shoe-leather costs

Answer 30

- costs people incur to minimise cash holdings during times of high inflation

Question 31

Menu costs

Answer 31

- costs incurred when changing a listed price (ie printing menus, altering website, etc.)

Question 32

Unit-of-account costs

Answer 32

- costs that are associated with the decline in the reliability of using money as a unit of account

Question 33

The process of bringing inflation down is called...

Answer 33

- disinflation

Question 34

Nominal interest rate

Answer 34

- = the interest rate before taking inflation into account

Question 35

___ is the nominal interest rate minus the rate of inflation.

Answer 35

- real interest rate.

Question 36

Who benefits from a higher-than-expected inflation rate and who doesn't?

Answer 36

- a higher inflation rate is good for borrowers and bad for lenders

Question 37

Why do higher inflation rates benefit borrowers?

Answer 37

- the money they pay back is worth less than what they originally paid

Question 38

Formula for finding the real interest rate

Answer 38

real interest rate = nominal interest rate - inflation rate