Questions for Week 2

Question 1

What are the main costs associated with high inflation?

Answer 1

Main costs include: Resource costs (menu and shoe-leather costs), Wealth redistribution (unexpected inflation benefits borrowers over lenders), Uncertainty (price signal noise and reduced money reliability over time), Tax distortions (bracket creep increases real tax burdens).

Question 2

How does inflation act as a ‘tax’?

Answer 2

Inflation erodes the real value of money, reducing purchasing power in a way similar to a tax, especially affecting savings and fixed incomes.

Question 3

What is substitution bias, and how does it affect inflation measurement?

Answer 3

Substitution bias occurs when CPI does not account for consumers switching to cheaper alternatives as prices change. This can lead to an overestimation of inflation.

Question 4

Calculate the change in the ‘cost-of-eating’ index if the cost of a food basket rises from $230 to $300.

Answer 4

The inflation rate for the cost of eating is 30.4%.

300−230/230×100%=30.4%.

Question 5

How does substitution bias affect the cost-of-eating index when consumers switch from 30 chickens to 15 hams due to a price increase?

Answer 5

Adjusting for substitution, the true cost increase is only 10.9%, not the official 30.4%, showing that CPI overestimates inflation without substitution adjustments.

Question 6

A family’s basket costs $950 in the base year and $1020 the following year. What is the CPI and inflation rate?

Answer 6

CPI = 1.074; Inflation rate = 7.4%.

CPI = 1020/950.

Question 7

If a family’s nominal income rises by 5% but inflation is 7.4%, are they better or worse off?

Answer 7

They are worse off, as the increase in nominal income does not keep pace with inflation, reducing their real purchasing power.

Question 8

If inflation expectations are underestimated, how does this impact wage negotiations?

Answer 8

Underestimating inflation can lead to wage increases that don’t keep up with actual inflation, eroding real wages and purchasing power.

Question 9

In March 2021, who made the most accurate inflation forecast, and why would this matter for unions?

Answer 9

Consumers forecasted closest at 4.1%, but actual inflation was 5.1%. Using the closest forecast helps unions negotiate wage increases that align with actual inflation.

Question 10

If Frank wants a 2% real return on a $1000 loan with expected 10% inflation, what nominal rate should he charge?

Answer 10

Frank should charge a nominal rate of 12%.

2% real return + 10% inflation.

Question 11

How could a loan be indexed to inflation to maintain a real return?

Answer 11

Frank and Sarah could adjust the interest rate yearly based on actual inflation; if inflation is 8% one year, Sarah would pay 10% interest (2% real + 8% inflation).

Question 12

In a closed economy, how do you calculate national savings if household saving is $200, business saving is $400, and public saving is -$120?

Answer 12

National savings = 480.

National savings = Private savings + Public savings = 600−120.

Question 13

How do you determine private saving if national saving is $525 and public saving is $100 in a closed economy?

Answer 13

Private saving = 425.

Private saving = National saving - Public saving = 525−100.

Question 14

Calculate GDP in an open economy if consumption is $4600, investment is $1000, government spending is $1000, and net exports are $12.

Answer 14

GDP = 6612.

Y=C+I+G+NX=4600+1000+1000+12.

Question 15

In the same open economy, how do you find national savings if GDP is $6612, consumption is $4600, and government spending is $1000?

Answer 15

National savings = 1012.

National savings = Y−C−G=6612−4600−1000.