Week 2 Flashcards
(27 cards)
What is the GDP Deflator, and how is it different from the CPI?
The GDP Deflator measures price changes in all goods and services produced domestically, while the CPI focuses on a fixed basket of consumer goods, making CPI a better measure of household cost of living.
How does the CPI use the concept of a ‘basket’ to measure price level changes?
CPI tracks the price of a representative basket of goods and services commonly purchased by households over time, adjusting only for price changes, not quantity or quality.
How is quarterly inflation calculated using CPI data?
Quarterly inflation = (CPI current - CPI previous) / CPI previous × 100%. It measures the percentage change from one quarter to the next.
What does it mean if the CPI rises from 133.7 to 138.8 in one year?
A rise from 133.7 to 138.8 in CPI means a year-ended inflation rate of approximately 3.8%, showing a general increase in price levels.
What is headline inflation vs. underlying inflation?
Headline inflation includes all items in the CPI basket, including volatile components like food and energy. Underlying inflation excludes these volatile items, providing a more stable inflation measure.
Why might the CPI overstate inflation? Name two biases that cause this.
Substitution bias (ignoring consumer substitution to cheaper goods) and quality bias (not adjusting for improved product quality) can cause CPI to overstate the actual cost of living changes.
Why is inflation compared to a tax?
Inflation reduces the real value of money, similar to how taxes reduce purchasing power by eroding money’s real worth over time.
How does inflation lead to bracket creep in a progressive tax system?
Inflation increases nominal incomes, pushing taxpayers into higher brackets even if their real income hasn’t improved, leading to higher effective tax rates without real gains.
What are ‘menu costs’ and ‘shoe-leather costs’ associated with inflation?
Menu costs refer to the cost of changing prices frequently (e.g., reprinting menus), and shoe-leather costs represent the effort spent minimising cash holdings to avoid value loss due to inflation.
What does the Fisher Equation illustrate in terms of interest rates?
The Fisher Equation: Nominal interest rate = Real interest rate + Inflation rate. It shows how lenders adjust nominal rates to account for expected inflation to preserve their real returns.
How does unanticipated inflation impact lenders and borrowers?
Lenders lose because the money repaid has less purchasing power, while borrowers gain by repaying with money that is worth less in real terms.
What is deflation, and why is it problematic for the economy?
Deflation is a persistent decrease in the price level, which can lead to higher real interest rates, discouraging investment and consumption, potentially leading to a deflationary spiral.
Why can deflation lead to a ‘zero lower-bound’ problem in interest rates?
When inflation is negative (deflation), nominal interest rates can’t go below zero, causing real rates to rise, which can further discourage borrowing and spending.
Refer to Fisher equation to assist with explanation.
Define the concept of ‘saving’ and distinguish it from ‘wealth’.
Saving is the portion of income not spent (flow), while wealth is the value of assets minus liabilities (stock). Saving adds to wealth over time.
What are precautionary savings, and why are they important?
Precautionary savings are reserves set aside for unforeseen expenses or economic downturns, providing financial security in emergencies.
Write the national savings identity and explain each term.
S = Y - (C + G) or S = (Y - T - C) + (T - G), where: S: National savings, Y: National income, C: Consumption, G: Government spending, T: Taxes.
What happens to investment if national savings decline?
If national savings decline and external borrowing doesn’t increase, available funds for investment decrease, possibly reducing investment and economic growth.
How does a government deficit affect interest rates and private investment?
A deficit can increase demand for loanable funds, driving up interest rates and ‘crowding out’ private investment as borrowing costs rise for businesses and consumers.
What is crowding out, and why does it matter?
Crowding out occurs when increased government borrowing reduces available funds for private sector investment, potentially slowing economic growth and private sector expansion.
What factors do firms consider when making investment decisions?
Firms assess the marginal benefit (expected return) vs. marginal cost (interest rate and price of capital) to decide if investment is profitable.
How does a rise in real interest rates impact a firm’s decision to invest?
Higher real interest rates increase borrowing costs, raising the threshold for profitable investment and possibly reducing overall investment levels.
How does inflation impact nominal loan contracts?
If inflation rises, the real value of loan repayments decreases, benefiting borrowers who repay with ‘cheaper’ money, while lenders effectively receive less in purchasing power.
What is indexation, and how can it protect against inflation?
Indexation adjusts nominal payments (e.g., wages or pensions) by inflation, ensuring purchasing power remains constant despite rising prices.
Explain with an example how inflation reduces real income.
If nominal income is $50,000 in 2023 with inflation at 5%, real income in 2024 would effectively need to be $52,500 to keep up with price increases; otherwise, purchasing power declines.
