067 - Chapter 67 - Inflation & Adjustment in Economics

Assume that the marginal propensity to save is 0.1. What is the maximum amount that real GDP could change if net exports increase by $15 billion?

$150 billion {Explanation - Using the formula, you get $15 billion * (1/0.1) = $150 billion.}

GDP Growth Rate Formula

(GDP in year 2 / GDP in year 1) - 1

comparing wages in 2 years

(Nominal wage in year 1 / CPI in year 1) x CPI in year 2

Inflation can result and increase because of the following four main factors

1) Increase in the money supply 2) The supply of goods going down 3) Demand for money going down 4) Demand for goods and services going up

simple spending multiplier

1/MPS; used to estimate how much total economic output will increase when some component of aggregate demand increases

A small island country had a seven percent increase in its money supply from the prior year and a three percent increase in real GDP. Calculate the change in the price level.

4% {Explanation - We can obtain the approximate change in the price level by subtracting the change in real GDP from the percentage change in the money supply: 7% - 3% = 4%}

Which one of these scenarios would cause Cost-Push Inflation?

A decrease in aggregate supply resulting in higher prices {Explanation - Cost-push inflation is a result of higher costs that ultimately lead to decreases in aggregate supply in the economy. As it gets more expensive to produce, firms produce less and less of a product, which puts upward pressure on prices.}

What is the result of cost-push inflation?

A higher equilibrium price and lower economic output. {Explanation - Economists illustrate cost-push inflation as a decrease, or a leftward shift, in the short-run aggregate supply curve, resulting in a higher equilibrium price and a lower economic output.}

Demand-Pull Inflation is illustrated by which of the following?

A rightward shift of the aggregate demand curve {Explanation - Demand-Pull inflation often results at high levels of employment or when employment is increasing in an economy. As more people have jobs, the aggregate demand in an economy increases. Firms will try and higher more people to keep up with demand. As more people are hired and earn money, demand continues to increase for even more goods, and the cycle continues. Each time Aggregate Demand (AD) increases it shifts to the right, resulting in higher prices.}

In year one, a worker's nominal wage is $25,000, and the CPI is 100. The following year, the worker's nominal wages stay the same, but the CPI is 105. In order to calculate the worker's real wage in year two, what needs to be done?

Adjust the nominal wage by inflation {Explanation - When the nominal wage stays the same between two different years, but prices rise, the real wage declines. To calculate the worker's real wage in year 2, you will need to adjust the nominal wage by inflation using the following formula: Real wage in a given year = (Nominal wage in a given year / CPI) * 100}

multiplier effect

An effect in economics in which an increase in spending produces an increase in national income and consumption greater than the initial amount spent.

In year one, nominal GDP is $5,000, while real GDP is $4,500. In year two, nominal GDP is $5,500, while real GDP is $4,800. What was the growth rate of real GDP between years one and two?

Around 7% {Explanation - The formula for calculating the growth rate of real GDP is: (Real GDP in Year 2 - Real GDP in year 1 ) / Real GDP in Year 1) Plugging our numbers into that formula gives us: ((4,800 - 4,500) / 4,500 ) = 0.0666, or approximately 7%.}

How does the multiplier effect resemble a ripple effect through the economy?

As people spend most of their earnings, money flows through the economy one person at a time. {Explanation - Because people spend most of the income they get, money flows through the economy one person at a time, like a ripple effect when a rock gets thrown into the water.}

Which of the following statements is FALSE regarding inflation?

FALSE: During the 1970s, it was extremely low. {Explanation - Everything is true except the statement about inflation being extremely low in the 1970s.}

Which of the following is considered the best measure of changes in prices by economists?

GDP deflator {Explanation - Economists consider the GDP deflator to be the best measure of changes in the price of a nation's gross domestic product because it doesn't depend on a fixed basket of goods.}

factors that cause demand-pull inflation

Increases in the money supply Increases in government spending Foreign growth or foreign price increases

Last year, an assembly-line worker earned $10 per hour when the Consumer Price Index (CPI) was 100. This year, the same worker earned $12 per hour, but the CPI has increased to 125. What happened to the worker's real wage?

It decreased. {Explanation - To answer this question, use the following formula: Real wage in a given year = (Nominal wage in that year / CPI) * 100 Plug the numbers from the question into the formula to solve for the worker's real wage. Real wage last year = (10 / 100) * 100 = $10 per hour Real wage this year = (12 / 125) * 100 = $9.60 per hour As you can see, even though the worker's nominal wage went up by $2 an hour, their real wage actually declined by 40 cents an hour once you adjust for inflation.}

What is the value of using real GDP?

It removes the effects of rising prices. {Explanation - Real GDP is the total market value of goods and services produced as measured in constant dollars. It removes the effect of inflation and rising prices. Nominal GDP can create a false impression of the amount of output taking place in a nation from one year to the next, so adjusting that GDP for inflation gives a much more accurate view of how much production really increased from one year to the next.}

Nominal GDP in year one was $16,000, while nominal GDP in year two was $19,320. Real GDP was $16,000 in year one and $15,500 in year two. What does this indicate about the economy?

It was in recession. {Explanation - Use the formula (GDP in Year 2 / GDP in Year 1) - 1 to calculate both the change in real and nominal GDP. Plugging the numbers from the question above into the formula gives you the following: Growth rate in real GDP = (15,500 / 16,000) - 1 = -0.03125, or -3.125% Growth rate in nominal GDP = (19,320 / 16,000) - 1 = 0.2075, or 20.8% The nominal GDP increased by 20.8%. However, the growth rate in real GDP was -3.125%. So while nominal GDP went up, real GDP went down, which indicates that the economy was in a recession.}

Which of the following is the correct formulation of the equation of exchange?

M x V = P x Y {Explanation - The equation of exchange illustrates how money supply, the velocity of money, and price level relate to each other. It is written as M * V = P * Y, where M stands for money supply, V stands for velocity of money, P stands for the average price level in the economy, and Y stands for the real GDP of the economy.}

Calculate Nominal GDP

Multiply the quantity of each good in a given year by its price in that year.

How is nominal GDP calculated?

Multiplying price x quantity in the same year for every good and finding the total. {Explanation - By definition, GDP is the total market value of goods and services produced. Since market value = price * quantity, it means that we multiply the price times the quantity for all goods in the economy and add them up for every year that we're looking at.}

How is real GDP calculated?

Multiplying the quantity x the price in a base year. {Explanation - To calculate real GDP in a certain year, multiply the quantities of goods produced in that year by the prices for those goods in the base year.}

In year one, nominal GDP is $5,000, while real GDP is $4,500. In year two, nominal GDP is $5,500, while real GDP is $4,800. Which of the following statements is TRUE?

Nominal GDP increased more than real GDP. {Explanation - Nominal GDP increased by $500 from Year 1 to Year 2, while real GDP increased by $300 from Year 1 to Year 2. Therefore, nominal GDP increased more than real GDP.}

GDP deflator

Nominal GDP/Real GDP x 100

Year CPI Nominal Wage 1 100 $40,000 2 110 $50,000 3 125 $50,000 Using the chart, which statement is true regarding wages over the three year period?

Nominal wages rose, while real wages stayed the same. {Explanation - To answer this problem, you will need to calculate the real wage in each of the three years and compare them. The formula to use is: Real wage = (Nominal wage in a year / CPI in a year) * 100 Plug the numbers from the table into the formula to get the real wage in each year. Real wage in Year 1 = (40,000 / 100) * 100 = $40,000 Real wage in Year 2 = (50,000 / 110) * 100 = $45,455 Real wage in Year 3 = (50,000 / 125) * 100 = $40,000 You can see from these numbers that while the nominal wage rose from $40,000 to $50,000 over the three-year period, the real wage stayed constant at $40,000.}

The Consumer Price Index (CPI) is based on a fixed basket of goods that the average citizen buys. The Substitution Bias causes this index to do which of the following?

Overstate the level of inflation {Explanation - The substitution bias is a weakness in the Consumer Price Index (CPI). Economists believe that the CPI overstates inflation because it doesn't account for the substitution effect.}

Which of the following would be negatively affected from unanticipated inflation?

People that own investments that pay a fixed rate of interest, such as bonds {Explanation - Unanticipated inflation hurts savers and creditors because the money lent out gets paid back in cheaper dollars time. It helps borrowers and debtors because they borrow money at a fixed rate and pay it back in cheaper dollars over time. People that own investments that pay a fixed rate of interest would be considered a saver/creditor, so they would be negatively affected by unanticipated inflation.}

What are the two reasons that economic output can increase?

Quantity increased and prices increased. {Explanation - Gross domestic product can increase for two reasons: because quantity increased or because prices increased.}

What occurs when the rate of unemployment goes up at the same time as inflation?

Stagflation {Explanation - Stagflation is the combination of a stagnant economy and inflation. It's when inflation and unemployment are going up at the same time.}

What happens if the rate of inflation as reported by the Consumer Price Index is 3%?

The actual rate of inflation may be lower because of the Substitution Effect. {Explanation - The Consumer Price Index (CPI) does not account for the substitution bias, which refers to how consumers will choose to substitute one good for another after its price becomes cheaper than the good they normally buy. Because of this weakness in the index, economists believe that the real rate of inflation is lower than what is reported.}

If the Consumer Price Index rises from 101 to 104, which of the following statements is true?

The average level of prices for a fixed basket of goods and services rises by 2.97%. {Explanation - 3/101 = 0.0297, or 2.97%. Because the level goes from 101 to 104, the level is rising, not falling.}

substitution bias

The inability of the CPI to account for consumers' substitution toward relatively cheaper goods and services

If the consumer price index is equal to 100 in year 1, and 103 in year 2, what does this mean?

The prices have risen by 3 percent. {Explanation - The consumer price index (CPI) is an index that measures the level of prices in the economy and compares them to previous years to gauge the level of inflation inside the economy. A change from 100 to 103 means that the prices increased by 3%.}

Why do economists use real GDP?

Using nominal GDP can create a false impression of the amount of output happening in the economy from one year to another. {Explanation - GDP is the total market value of goods and services produced within the domestic borders of a nation during the year. Nominal GDP is the total market value of goods and services produced, measured in current dollars, while real GDP is the total market value of goods and services produced, measured in constant dollars. Nominal GDP can create a false impression of the amount of output taking place in a nation from one year to the next, so economists adjust that number for inflation to get the real GDP.}

Calculate Real GDP

a measure of GDP in which the quantities produced are valued at the prices in a base year rather than at current prices; measures the actual physical volume of production

deflation

a sustained decrease in the level of prices in an economy

Inflation

a sustained increase in the average level of prices in the economy

cost-push inflation

a type of inflation that occurs when higher production costs push up the prices of goods and services Causes of cost-push inflation include things like: - oil shocks - higher wages - rising cost of raw materials

equation of exchange

an equation that shows us how money supply, the velocity of money, and price level relate to each other; M * V = P * Y M stands for the money supply, while V stands for the velocity of money. On the other side of our equation, P stands for the average price level in the economy, while Y is the real GDP of the economy

Consumer Price Index (CPI)

an index measuring the level of prices in the economy and comparing them to previous years in order to gauge the level of inflation inside the economy. It's based on a fixed basket of goods that an average person buys each year.

Real GDP evaluates _____ production at _____ prices.

current; past {Explanation - Real gross domestic product (real GDP) is the total market value of goods and services produced, measured in constant dollars. It represents 'current quantities at past prices.' Nominal gross domestic product (nominal GDP) is the total market value of goods and services produced, measured in current dollars. It represents 'current quantities at current prices.'}

Cost-push inflation occurs when _____.

higher production costs push up prices {Explanation - Cost-push inflation is a type of inflation that occurs when higher production costs push up the prices of goods and services.}

Unexpectedly high inflation _____ savers and _____ borrowers.

hurts; helps {Explanation - Unanticipated inflations hurts savers and creditors because the money lend out gets paid back in cheaper dollars over time. It helps borrowers and debtors because they borrow money at a fixed rate and pay it back in cheaper dollars over time.}

demand-pull inflation

inflation that is caused by an increase in aggregate demand; results when prices rise because aggregate demand in an economy is greater than aggregate supply

anticipated inflation

inflation that is expected; a sustained increase in the price level that is expected ahead of time

unanticipated inflation

inflation that is not expected; a higher-than-expected sustained increase in the price level; in other words, prices are going up faster than what was expected

real wage calculation

real wage = (the nominal wage in year one / CPI in year one) x CPI in year two

real wage in a given year calculation

real wage in a given year = (nominal wage in that year / CPI in that year) x 100.

real wage rate calculation

real wage rate = (the nominal wage rate in year one / CPI in year one) x CPI in year two

stagflation

the combination of a stagnant economy and inflation. It's when inflation and unemployment are going up at the same time

Marginal Propensity to Consume (MPC)

the increase in consumer spending when disposable income rises by $1; how much, in percentage terms, of extra income that consumers will spend

Marginal Propensity to Save (MPS)

the increase in household savings when disposable income rises by $1; the percentage of extra income that consumers save

GDP or Gross Domestic Product

the market value of all final goods and services produced within a country's domestic borders, and it's usually quoted on an annual basis

real wage

the nominal wage in a given year in terms of the price level in a previous year

velocity of money

the rate at which money changes hands V = (P x Y) / M

Gross domestic product

the total market value of goods and services produced within the domestic borders of a nation during the year

real gross domestic product (or "real GDP")

the total market value of goods and services produced, measured in constant dollars. What that means is it represents 'current quantities at PAST prices.'

Nominal gross domestic product (or "nominal GDP")

the total market value of goods and services produced, measured in current dollars. It represents 'current quantities at current prices.'

money supply

the total supply of money currently in the economy

nominal wage

the wage in basic dollar terms

The rate at which money is moved around an economy is known as the _____.

velocity of money {Explanation - The velocity of money refers to how fast money passes from other person to another through economic transactions over a period of time.}

substitution effect

when consumers react to an increase in a good's price by consuming less of that good and more of other goods; when consumers choose to substitute one good for another after its price becomes cheaper than the good they normally buy