Ch 11

The Consumer Price Index (CPI) is constructed by

The CPI is constructed from a "market basket" sampling of goods that consumers typically purchase. Prices for goods in the market basket are collected each month, weighted by the importance of the good in the basket (cars are more expensive than bread, but we buy a lot more bread), and averaged to form the price level.

What are the two primary phases of the business cycle? What tends to happen to real GDP, unemployment, and inflation during these phases?

The two primary phases are expansions and recessions. During an expansionary phase, real GDP rises, inflation occurs, and unemployment falls. During a recessionary phase, real GDP declines, unemployment increases, and inflation is mild or falling.

Deflation means that the price level is falling, whereas with inflation, overall prices are rising.

Deflation means that the price level is falling, whereas with inflation overall prices are rising. Deflation is undesirable because the falling prices mean that incomes are also falling, which reduces spending, output, employment, and, in turn, the price level (a downward spiral). Inflation in modest amounts (< 3 percent) is tolerable, although there is not universal agreement on this point.

Demand-pull inflation occurs when

Demand-pull inflation occurs when prices rise because of an increase in aggregate spending not fully matched by an increase in aggregate output. It is sometimes expressed as "too much spending (or money) chasing too few goods." Cost-push inflation describes prices rising because of increases in per-unit costs of production. Cost-push inflation is most likely to be associated with a negative GDP gap, as the rising production costs reduce spending and output.

Inflation

Inflation reduces the purchasing power of the dollar. Facing higher prices with a given number of dollars means that each dollar buys less than it did before.

How does unanticipated inflation hurt creditors and help borrowers?

The creditors are hurt as they receive dollars of lesser value from borrowers.

How can anticipating the inflation make these effects less severe?

The effects are made less severe by adjusting nominal interest.

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

The rate of inflation in the CPI approximates the difference between the nominal and real interest rates. A nominal interest rate of 10 percent with a 6 percent inflation rate will mean that real interest rates are approximately 4 percent.

What are the three types of unemployment? Unemployment is seen by some as undesirable. Are all three types of unemployment undesirable?

The three types of unemployment are frictional, structural, and cyclical. Although unemployment may be seen as undesirable, frictional unemployment is desirable because the search process allows workers to move into higher-paying, more productive jobs. This provides greater income for workers, a better allocation of labor resources, and an increase in the production of goods and services for the economy.

The United States has an unemployment compensation program that provides income for those out of work. Unemployment is

The unemployment compensation program merely gives the unemployed enough funds for basic needs. Furthermore, many of the unemployed do not qualify for unemployment benefits. The programs apply only to those workers who were covered by the insurance, and this may be as few as one-third of those without jobs. Most of the unemployed get no sense of self-worth or accomplishment out of drawing this compensation. Moreover, from the economic point of view, unemployment is a waste of resources; when the unemployed go back to work, nothing is forgone except undesired leisure. Finally, unemployment could be inflationary and costly to taxpayers: The unemployed produce nothing—their supply is zero—but the compensation helps keep demand in the economy high.

The Bureau of Labor Statistics (BLS) would calculate the rate of inflation in year 5 by

To calculate the rate of inflation for year 5, the BLS subtracts the CPI of year 4 from the CPI of year 5, and then divides by the CPI of year 4 (percentage change in the price level).

Hyperinflation might lead to a severe decline in total output if

With inflation running into the double, triple, quadruple, or an even greater number of digits per year, it makes little sense to save. The only sensible thing to do with money is to spend it before its value is cut in half within a month, a week, or a day. This very fact of everyone trying to spend as fast as possible will speed the inflationary spiral and cause people to spend more and more time trying to figure out what goods are most likely to go up fastest in price. More and more people will turn away from productive activity because wages and salaries are not keeping up with inflation. Instead, they will spend their time speculating, transferring goods already in existence and producing nothing. Eventually, money may become worthless. No one will work for money. Barter and living by one's wits become the only means of survival. Production falls for this reason and also because investment in productive capital practically ceases. Unemployment soars. A massive depression is at hand.