ECON 103 Chapter 11 Quiz

If the quality of a good deteriorates from one year to the next while its price remains the same, why does the value of the dollar fall?

B/c you are getting a lesser good from the same amount of money.

What is the major explanation for differences in regional prices?

Services - The cost of transporting services across states is costly while goods like clothing are not. - Housing services particularly are important b/c once they are built, they cannot be moved, therefore differences in housing costs can be large

When calculating the cost of each basket, by keeping the basket of goods the same (and therefore the quantity of goods the same each year), what is isolated?

The effects of price changes is isolated from the effects of any quantity changes that might be occurring at the same time

What is the inflation rate?

The percentage change in the price level from the previous period

What is the problem of substitution bias?

The price index is computed assuming a fixed basket of goods, therefore the amount of a good you buy every year remains the same. Thus, the CPI ignores the possibility of consumer substitution and thus overstates the increase in the cost of living from one year to the next. Even though you buy less of a more expensive good, the CPI records you buying the same amount of amore expensive good, so the price of the basket increases even though you're buying cheaper goods. Therefore, the CPI ends up overstating inflation

Substitution bias results in an (increase/decrease) in the cost of living than consumers actually experience.

increase

Due to the issue of unmeasured quality change, the CPI (overstates/understates) increases in the cost of living.

overstates

The introduction of new goods results in the CPI (overstating/understating) increases in the cost of living.

overstating

What are the 3 major problems with the CPI, making it an imperfect measure of the cost of living?

1. Substitution Bias 2. Introduction of New Goods 3. Unmeasured Quality Change

What is the Consumer Price Index (CPI)?

A measure of the overall cost of the goods and services bought by a typical consumer AKA measures the cost of living for only consumer goods (by households)

What is a cost-of-living allowance (COLA)?

A provision where some long-term contracts between firms and unions include partial or complete indexation of the wages to the CPI. It automatically raises the wage when CPI rises

What is inflation?

A situation in which the economy's overall price level is rising

What is the equation for turning dollar figures from year T into today's dollars?

Amount in today's dollars = Amount in year T dollars × (price level today / price level in year T)

How do consumers respond to differing price changes?

By buying less of the goods whose prices have risen by relatively large amounts and buying more of the goods whose prices have risen less or perhaps even fallen

What is the equation for calculating the CPI?

CPI = (price of basket of goods and services in current year / price of basket in base year) × 100

How are prices used in calculating the CPI?

Find the prices of each of the goods and services in the basket at each point in time - the prices for the same good/service will differ depending on the basket, since the prices differ each year and there is only one basket per year

When computing the CPI, what is the base year?

One year that serves as the benchmark against which other years are to be compared

What is a measure of the price level?

Price index like the CPI

T/F: Both the CPI and the GDP Deflator are measures of the overall level of prices in the economy

T

T/F: The choice of base year is arbitrary b/c the index is used to measure the percentage change in the cost of living, therefore these changes are the same regardless of the choice of base year.

T

T/F: When prices change from one year to the next, they do not all change proportionately. Some prices rise more than others

T

Which aspect of the GDP equation does the CPI concern? GDP = C + I + G + NX

The C (consumption)

What is the Core CPI? Why is this important?

The CPI for all goods and services excluding food and energy - B/c food and energy (gas) prices show substantial short-run volatility and can change abruptly, therefore the core CPI better reflects underlying inflation trends

What are regional price parities?

The statistic that is the result of the Bureau of Economic Analysis using the data collected for the CPI to compare prices around the US

What are price indexes used for?

To correct for the effects of inflation when comparing dollar figures from different times

The cost of living varies not only over time but also across ______.

locations

When CPI rises, the typical family has to spend (more/less) money to maintain the same standard of living.

more

If the quality of a good rises from one year to the next, does the value of the dollar rise or fall?

rise

How is the GDP Deflator calculated?

(NGDP / RGDP) × 100

Explain how the following types of goods affect the CPI and the GDPD: - consumer goods - capital goods - domestic goods - foreign goods

- CPI: Measures consumer goods (NOT capital), the fact that a good is domestic or foreign doesn't matter - GDPD: Only measures domestic goods (NOT foreign), the fact that a good is a consumer or capital good doesn't matter

What is the difference between the CPI and regional price parities?

- CPI: measures variations in the cost of living from year to year - Regional Price Parities: measure the variation in the cost of living from state to state

Ex.: Suppose that the price of an airplane produced by Boeing and sold to the Air Force rises. How does this transaction effect the CPI and GDPD?

- GDP increases b/c it was produced in the US - CPI is not affected b/c the airplane is not a consumer good, it's a capital good

How are the CPI and the GDPD different in terms of the type of goods they consider?

- GDPD reflects the prices of all goods and services produced domestically - CPI reflects the prices of all goods and services bought by consumers

How do you know which prices are more important to the typical consumer when calculating the CPI?

- If the consumer buys more of one good/service than another, than that good/service is more important. Therefore, the good/service is given more weight in measuring the cost of living than the other. - Ex. If the typical consumer buys more hot dogs than hamburgers, then the price of hot dogs is more important than the price of hamburgers, therefore it should be given greater weight in measuring the cost of living

How are the CPI and the GDPD different in terms of how they are calculated?

- When calculating the CPI, the price of the fixed basket of goods for each year is compared. The type of good looked at does not change. The quantity of goods does not change, but the prices do change each year when calculating the basket. - When calculating the GDPD, the price of goods and services currently produced is compared with the goods and services of the base year. The type of good looked at changes.

What is the CPI used for?

- monitor changes in the cost of living over time - Used to compare dollar figures from different points in time

Ex.: The US produced some oil, but much of the oil we use is imported. How does this effect the CPI and GDPD?

- the GDPD only rises in the amount of the amount of oil produced in the US - The CPI rises much more than the GDPD b/c most of US oil is produced overseas, therefore it takes up a much larger share of the CPI than GDPD since CPI doesn't care if a good is foreign or domestic, and oil is a consumer good

When there is more variety of goods to choose from, dollars become more _______. Since you have more choices, you should have a (lower/higher) cost of living.

- valuable - lower

What is the problem of the introduction of new goods on the CPI?

As new goods are introduced, consumers have more choices, therefore each dollar is worth more. But b/c the CPI is based on the fixed basket of goods and services, it doesn't reflect the increase in the value of the dollar that results from the introduction of new goods

Why is the PPI often thought to be useful for predicting changes in the CPI?

B/c firms eventually pass on their costs to consumers in the form of higher consumer prices. - If the amount firms pay goes up, the amount consumers have to pay them goes = If PPI goes up, CPI goes up

When a new good is introduced, how does this affect consumers?

Consumers have more variety from which to choose and allows them to find products that more closely meet their needs

Ex.: Say that "housing prices" and "medical care prices" increased 10% each. How much would they contribute to the change in the CPI (%)? - Weights: 41% housing, 9% housing

If housing cost were to increase by 10%, CPI would increase by (0.41 x 10) = 4.1%

How do you compare a past price with today's price?

Inflate the past price in order to turn the past price into today's dollars

What is the equation for the inflation rate between two consecutive years using the CPI?

Inflation Rate in Year 2 = [(CPI in year 2 - CPI in year 1) / (CPI in year 1)] × 100

What is the Producer Price Index (PPI)?

Measures the cost of a basket of goods and services bought by firms rather than consumers

Ex.: Ruth's salary in 1931 was $80,000. The CPI in 1931 was 15.2. The CPI in 2018 was 251. Use these numbers to measure Ruth's salary in 2018 dollars.

Salary in 2018 dollars = 80,000 × (251/15.2) = $1,321,053

What is does it mean to be "indexed for inflation"?

When some dollar amount is automatically corrected for changes in the price level by law or contract

What is the issue of the unmeasured quality change when measuring CPI?

When the quality of a good in the basket changes, the Bureau tries to adjust the price of the good to account for the quality change. However, changes in quality are hard to measure. Since the quantity of goods in the basket change, it is like you're computing the price of a basket of goods of constant quality every year