Ch. 11 Econ

inflation rate formula

(CPI this year - CPI last year) / CPI last year x 100

CPI formula

(basket's cost in current year / basket's cost in base year) * 100

GDP deflator formula

(nominal/real GDP) * 100

GDP deflator vs CPI: oil example

- US produces some oil - lots of oil we use is imported - so, gas and heating oil make up alot more consumer spending than GDP - CPI rises much more than GDP deflator

problem with CPI: unmeasured quality change

- improvements in the quality of goods in the basket increase the value of each dollar - BLS tires to account for quality chnages but prob misses some, hard to measure - so, CPI overstates increase cost of living

problem with CPI: introduction of new goods

- more variety, allows consumers to find products that more closely meet their needs - so, dollard become more valuable - CPI misses this effect bc it uses a fixed basket of goods - so, the CPI overstates increased in the cost of living

problem with CPI: substitution bias

- over time, some prices rise faster than others - consumers substitute toward goods that become relatively cheaper cheaper, mitigating the effects of price increases - the CPI misses this substitution becuase it uses a fixed basket of goods, so the CPI overstates in the cost of living

reasons for overstating CPI (HW)

1. One reason that price indexes such as the CSPI overstate inflation is that they use a fixed basket of goods. In reality, when the price of a good increases, people tend to buy less of it. 2. assume the quality of a good doesn't change from year to year. Therefore, if the price of something increases because of increases in quality, the price index might overstate the cost increase of that item due to unmeasured quality improvements. 3. don't account for the benefits of new goods. When new goods, like new mobile devices for personal computing, are introduced, consumers can spend their money on more things. As a result, the value of each dollar they have increases. Because the CSPI doesn't account for new goods, it underestimates what a dollar is worth when new goods are introduced and, thus, overestimates inflation.

when solving for CPI shortcut

1. basket 2. CPI 3. inflation rate

how CPI is calculated

1. fix the basket 2. find the prices 3. compute the basket's cost 4. choose a baseyear and compute the CPI 5. compute the inflation rate

3 problems with CPI

1. substitution bias SOME PRICES RISE FASTER THAN OTHERS 2. introduction of new goods VARIETY 3. unmeasured quality change QUALITY IMPROVEMENTS all increase cost of living

The CPI for "All Items" was 250.546 in April 2018, and 255.548 in April 2019. Over this period, the rate of inflation as measured by the rate of change of the CPI was

2%

real interest rate formula

= nominal interest rate - inflation rate

fixed basket

A set group of goods and services whose quantities do not change over time. This is used, for instance, in the calculation of the CPI.

Which of the following, if true, would illustrate why price indexes such as the CSPI might overstate inflation in the cost of going to college? Check all that apply. As the price of calculators rose, fewer students decided to buy them, opting instead to use the free calculators in their cell phones or on their computers. Energy drinks became increasingly popular on college campuses between 2017 and 2019 due to significant improvements in flavor, but this quality change is hard to measure. Professors required each student to buy 15 notebooks, regardless of the price. A new mobile device for personal computing became available for purchase.

As the price of calculators rose, fewer students decided to buy them, opting instead to use the free calculators in their cell phones or on their computers. Energy drinks became increasingly popular on college campuses between 2017 and 2019 due to significant improvements in flavor, but this quality change is hard to measure. A new mobile device for personal computing became available for purchase.

GDP or CPI An increase in the price of a Chinese-made television that is popular among U.S. consumers and A decrease in the price of a Waterman Industries deep-water reel, which is a commercial fishing product used for deep-sea fishing, made in the U.S., but not bought by U.S. consumers

CPI The increase in the price of the Chinese-made television will show up in the U.S. CPI because it reflects the prices of products purchased by typical U.S. consumers. The price change will not affect the GDP deflator because the GDP deflator reflects the prices of domestically produced goods and services. GDP The decrease in the price of the fishing equipment will show up in the GDP deflator because the deflator reflects the prices of all domestically produced products. The price change will not impact the consumer price index because commercial fishing equipment is not bought by a typical U.S. consumer.

2 measures of inflation

CPI and GDP

GDP deflator vs CPI

Deflator: reflects the prices of all goods and services PRODUCED DOMESTICALLY CPI: reflects the prices of all goods and services BOUGHT BY CONSUMERS

True or False: If you were to learn that a bottle of Gatorade increased in size from 2020 to 2021, that information would raise your estimation of the inflation rate.

F, lower

True or False: If you were to learn that Gatorade introduced new flavors in 2021, that would imply that the inflation rate you estimated is understated.

F, overstate

Which of the following situations illustrate the problem of unmeasured quality change in the construction of the CPI? Increased personal computer purchases in response to a decline in their price More scoops of raisins in each package of Raisin Bran The invention of cell phones The introduction of air bags in cars Greater use of fuel-efficient cars after gasoline prices increase

More scoops of raisins in each package of Raisin Bran The introduction of air bags in cars

substitution bias

Over time, some prices rise faster than others. Consumers substitute toward goods that become relatively cheaper, mitigating the effects of price increases. The CPI misses this substitution because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living.

indexation

a dollar amnt is indexed for inflation if its automatically corrected for inflation by law/in a contract

If inflation is 8 percent and the real interest rate is 3 percent, then the nominal interest rate should be a. 11 percent. b. 3/8 percent. c. 5 percent. d. 24 percent. e. −5 percent.

a. 11 percent.

In 1989, the CPI was 124.0. In 1990, it was 130.7. What was the rate of inflation over this period? a. 5.4 percent b. 5.1 percent c. 30.7 percent d. You can't tell without knowing the base year. e. 6.7 percent

a. 5.4 percent

Which of the following would likely cause the CPI to rise more than the GDP deflator? a. an increase in the price of Hondas produced in Japan and sold in the United States b. an increase in the price of domestically produced fighter planes sold exclusively to Israel c. an increase in the price of John Deere tractors d. an increase in the price of Fords e. an increase in the price of tanks purchased by the military

a. an increase in the price of Hondas produced in Japan and sold in the United States

If workers and firms agree on an increase in wages based on their expectations of inflation and inflation turns out to be more than they expected, a. firms will gain at the expense of workers. b. workers will gain at the expense of firms. c. neither workers nor firms will gain because the increase in wages is fixed in the labor agreement. d. none of the above is true.

a. firms will gain at the expense of workers.

The CPI will be most influenced by a 10 percent increase in the price of which of the following consumption categories? a. housing b. transportation c. medical care d. food and beverages e. All of the above would produce the same impact.

a. housing

If there is an increase in the price of apples that causes consumers to purchase fewer pounds of apples and more pounds of oranges, the CPI will suffer from a. substitution bias. b. bias due to the introduction of new goods. c. bias due to unmeasured quality change. d. base-year bias. e. none of the above.

a. substitution bias.

Because consumers can sometimes substitute cheaper goods for those that have risen in price, a. the CPI overstates inflation. b. the CPI understates inflation. c. the GDP deflator overstates inflation. d. the GDP deflator understates inflation.

a. the CPI overstates inflation.

CPI overstate

an error, difference the CPI estimate and what the estimate would be if the CPI was able to collect all prices

Cost-of-living allowance (COLA)

automatically raises the wage when CPI rises

Which of the following statements is correct? a. The real interest rate is the sum of the nominal interest rate and the inflation rate. b. The real interest rate is the nominal interest rate minus the inflation rate. c. The nominal interest rate is the inflation rate minus the real interest rate. d. The nominal interest rate is the real interest rate minus the inflation rate. e. None of the above is true.

b. The real interest rate is the nominal interest rate minus the inflation rate.

The largest component in the basket of goods and services used to compute the CPI is a. food and beverages. b. housing. c. apparel. d. medical care.

b. housing.

If borrowers and lenders agree on a nominal interest rate and inflation turns out to be less than they had expected, a. borrowers will gain at the expense of lenders. b. lenders will gain at the expense of borrowers. c. neither borrowers nor lenders will gain because the nominal interest rate has been fixed by contract. d. none of the above is true.

b. lenders will gain at the expense of borrowers.

You deposit $2,000 in a savings account, and a year later you have $2,100. Meanwhile, the CPI rises from 200 to 204. In this case, the nominal interest rate is _____ percent, and the real interest rate is _____ percent. a. 1, 5 b. 3, 5 c. 5, 3 d. 5, 1

c. 5, 3

Under which of the following conditions would you prefer to be the borrower? a. The nominal rate of interest is 12 percent and the inflation rate is 9 percent. b. The nominal rate of interest is 15 percent and the inflation rate is 14 percent. c. The nominal rate of interest is 20 percent and the inflation rate is 25 percent. d. The nominal rate of interest is 5 percent and the inflation rate is 1 percent.

c. The nominal rate of interest is 20 percent and the inflation rate is 25 percent. highest inflation rate

The "basket" on which the CPI is based is composed of a. raw materials purchased by firms. b. total current production. c. products purchased by the typical consumer. d. consumer production. e. none of the above.

c. products purchased by the typical consumer.

Suppose your income rises from $19,000 to $31,000 while the CPI rises from 122 to 169. Your standard of living has likely a. stayed the same. b. You can't tell without knowing the base year. c. risen. d. fallen.

c. risen.

The CPI measures approximately the same economic phenomenon as a. the unemployment rate. b. nominal GDP. c. the GDP deflator. d. real GDP.

c. the GDP deflator.

CPI monitors what?

changes in the cost of living over time

real interest rate

corrected for inflation

If the CPI is 200 for the year 1980 and 300 today, then $600 in 1980 has the same purchasing power as ________ has today. a. $700 b. $400 c. $500 d. $900

d. $900

Under which of the following conditions would you prefer to be the lender? a. The nominal rate of interest is 15 percent and the inflation rate is 14 percent. b. The nominal rate of interest is 12 percent and the inflation rate is 9 percent. c. The nominal rate of interest is 20 percent and the inflation rate is 25 percent. d. The nominal rate of interest is 5 percent and the inflation rate is 1 percent.

d. The nominal rate of interest is 5 percent and the inflation rate is 1 percent. lowest inflation rate

Inflation can be measured by all of the following except the a. GDP deflator. b. consumer price index. c. producer price index. d. finished goods price index. e. All of the above are used to measure inflation.

d. finished goods price index.

The main reason the cost of living varies across regions of the country is differences in the price of a. clothing. b. food. c. medical care. d. housing

d. housing

If a Pennsylvania gun manufacturer raises the price of rifles it sells to the U.S. Army, its price hikes will increase a. both the CPI and the GDP deflator. b. neither the CPI nor the GDP deflator. c. the CPI but not the GDP deflator. d. the GDP deflator but not the CPI.

d. the GDP deflator but not the CPI.

If the nominal interest rate is 7 percent and the inflation rate is 3 percent, then the real interest rate is a. −4 percent. b. 10 percent. c. 21 percent. d. 3 percent. e. 4 percent.

e. 4 percent.

True or False: If the elderly consume the same market basket as other people, then Social Security would provide a decrease in their standard of living.

false

typical basket examples

housing, transportation, medical care, apparel etc rlly just the price chnages between years

unmeasured quality change

improvements in the quality of goods in the basket increases the value of each dollar hard to measure, so CPI overstates in the cost of living

imported consumer goods

included in CPI but excluded from GDP deflator

intro of new goods

increase variety, allows consumers to find products that more closely meet their needs so, dollars become more valuable missed bc CPI uses a fixed value of goods, so overstates increase cost of living

nominal interest rate

interest rate not corrected for inflation - rate of growth in the dollar value of a deposit/debt

cola further

is many multi-year labor contracts - adjustments in social security payments and fed inc tax brackets

Produce Price Index (PPI)

measures cost of a basket of goods and services bought by firms ex) cotton, gas, steel

Core CPI

measures overall cost of consumer goods and services EXCLUDING food and energy

Consumer Price Index (CPI)

measures overall goods and services bought by a typical consumer

value of a basket

nom GDP formula

inflation rate represents?

percentage change in the CPI from the preceding period

3 reasons CPI is overstated

substitution bias, into of new goods, unmeasured quality change

GDP

the market value of all final goods and services produced within a country in a given period of time

Healthcare costs have risen faster than overall inflation. True or False: If the elderly consume a market basket that includes more healthcare than other people, then Social Security would have an uncertain impact on their standard of living.

true

True or False: When one calculates a single rate of inflation using the CPI for "All Items," it does not necessarily mean that all categories of goods and services experienced the same rate of price change over that period.

true

Suppose that a borrower and a lender agree on the nominal interest rate to be paid on a loan. Then inflation turns out to be lower than they both expected. True or False: The real interest rate on this loan is higher than expected. The lender gains from this unexpected lower inflation, and the borrower loses under these circumstances.

true The lender GAINS from this unexpected lower inflation, and the borrower LOSES under these circumstances.

real GDP

w/ base year prices

nominal GDP

w/ inflation = current prices