Chapter 9 - Inflation

In Iowa, the price of a paperback novel was $1 in 1950 and $7 in 2010. Iowa's CPI was 30 in 1950 and 150 in 2010. What is the 1950 price of a paperback novel in 2010 dollars?

1950 price of paperback novel in $2010 = $5

Ella has two job offers: a job in Chicago at an annual salary of $80,000 and a job in Tucson at an annual salary of $70,000. The CPI for Chicago is 230, and the CPI for Tucson is 200. Which job offer should Ella accept if she wants to maximize her purchasing power?

Ella should take the job in Tucson: Chicago salary in $Chicago = $80,000 Tucson salary in $Chicago = $80,500 OR Chicago salary in $Tucson = $69,565 Tucson salary in $Tucson = $70,000

A decrease in the price of domestically-produced aircraft carriers will be reflected in both the CPI and the GDP deflator.

False

An increase in the price of imported rice will be reflected in both the CPI and the GDP deflator.

False

If the nominal interest rate is 1% per year and the inflation rate is -2% per year, then the real interest rate is -1% per year.

False

If the nominal interest rate is 7% per year and the inflation rate is 2% per year, then the cost of borrowing in terms of dollars is 5% per year.

False

If the price of a firm's product increases because of inflation, then the firm should increase the quantity of the product it supplies.

False

When an economy is experiencing inflation, the prices of all goods and services in the economy are rising.

False

Borrowers prefer inflation to be higher than expected.

True

If the CPI equals 370 in the current year, then the price level is 270 percent higher in the current year than it was in the base year.

True

Inflation reduces the incentive to save when a government taxes nominal, rather than real, interest.

True

Last year, the nominal interest rate was 3% per year and the inflation rate was -1% per year, so the number of dollars in a savings account increased by 3% last year, and the purchasing power of a savings account increased by 4% last year.

True

Substitution bias, quality bias, new product bias, and outlet bias all cause the CPI to overstate the annual inflation rate.

True

The average person's purchasing power is not affected by inflation in the long run.

True

Uncertainty about future prices makes contracts riskier and limits future production.

True

When inflation is lower than expected, the dollars paid by borrowers to lenders have more purchasing power than expected.

True

f your income rises slower than the price level, then the purchasing power of your income will fall.

True

Which of the following is incorrect about deflation?

Unanticipated deflation causes a redistribution of wealth from lenders to borrowers.

A typical urban family of four in the country of Hawkeye consumes 1,000 cups of coffee and 500 donuts per year. The table below shows prices in Hawkeye for five years. The base year is 2006. Year Price of a cup of coffee Price of a donut 2005 $1 $1 2006 $1 $2 2007 $2 $3 2008 $2 $2 2009 $3 $4 a. What was the cost of the basket in 2006, the base year? b. What was the cost of the basket in 2008? c. What was the cost of the basket in 2009? d. What was the CPI in 2008? e. What was the CPI in 2009? f. What was the inflation rate in 2009?

a. cost of basket in 2006 = $2,000 b. cost of basket in 2008 = $3,000 c. cost of basket in 2009 = $5,000 d. CPI in 2008 = 150 e. CPI in 2009 = 250 f. inflation rate in 2009 = 66.7%

When an economy is experiencing deflation,

firms lay off workers.

In Hawkeye, the real interest rate is 4%, the inflation rate is 1%, and nominal interest is taxed at a rate of 10%. a. What is the nominal interest rate in Hawkeye? b. What is the tax on nominal interest in Hawkeye? c. What is the after-tax real interest rate in Hawkeye? d. If real, rather than nominal, interest is taxed at a rate of 10%, then what is the tax on real interest and the after-tax real interest rate in Hawkeye? e. Answer questions a-d using an inflation rate of 10% instead of 1%.

nominal interest is taxed, 1% inflation rate a. nominal interest rate - inflation rate = real interest rate nominal interest rate = real interest rate + inflation rate = 4% + 1% = 5% b. tax on nominal interest = (nominal interest rate)(tax rate) = (5%)(0.10) = 0.5% c. after-tax real interest rate = real interest rate - tax on nominal interest = 4% - 0.5% = 3.5% real interest is taxed, 1% inflation rate d. tax on real interest = (real interest rate)(tax rate) = (4%)(0.10) = 0.4% after-tax real interest rate = real interest rate - tax on real interest = 4% - 0.4% = 3.6% Note that when nominal, rather than real, interest is taxed, an inflation rate of 1% reduces the after-tax real interest rate (i.e., the incentive to save) from 3.6% to 3.5%. That's not a very big reduction, but... e. nominal interest is taxed, 10% inflation rate (a) nominal interest rate - inflation rate = real interest rate nominal interest rate = real interest rate + inflation rate = 4% + 10% = 14% (b) tax on nominal interest = (nominal interest rate)(tax rate) = (14%)(0.10) = 1.4% (c) after-tax real interest rate = real interest rate - tax on nominal interest = 4% - 1.4% = 2.6% real interest is taxed, 10% inflation rate (d) tax on real interest = (real interest rate)(tax rate) = (4%)(0.10) = 0.4% after-tax real interest rate = real interest rate - tax on real interest = 4% - 0.4% = 3.6% ...when nominal, rather than real, interest is taxed, an inflation rate of 10% reduces the after-tax real interest rate from 3.6% to 2.6%. So, when nominal, rather than real, interest is taxed, not only does inflation reduce the incentive to save, but that reduction increases as the inflation rate increases. If a government were to choose to tax real, rather than nominal, interest, then inflation would have no effect on the incentive to save.

Changes in _____ are the best measure of changes in the cost of living as experienced by a typical household.

the CPI