Review Questions

4 . Edna is living in a retirement home where most of her needs are taken care of, but she has some discretionary spending. Based on the basket of goods in Table 9.5, by what percentage does Edna’s cost of living increase between time 1 and time 2? Items Quantity (Time 1) Price (Time 2) Price Gifts for grandchildren 12 $50 $60 Pizza delivery 24 $15 $16 Blouses 6 $60 $50 Vacation trips 2 $400 $420 TABLE 9.5 5 . How to Measure Changes in the Cost of Living introduced a number of different price indices. Which price index would be best to use to adjust your paycheck for inflation? 6 . The Consumer Price Index is subject to the substitution bias and the quality/new goods bias. Are the Producer Price Index and the GDP Deflator also subject to these biases? Why or why not? 7 . Go to this website (http://www.measuringworth.com/ppowerus/) for the Purchasing Power Calculator at MeasuringWorth.com. How much money would it take today to purchase what one dollar would have bought in the year of your birth? 8 . If inflation rises unexpectedly by 5%, would a state government that had recently borrowed money to pay for a new highway benefit or lose? 9 . How should an increase in inflation affect the interest rate on an adjustable-rate mortgage? 10 . A fixed-rate mortgage has the same interest rate over the life of the loan, whether the mortgage is for 15 or 30 years. By contrast, an adjustable-rate mortgage changes with market interest rates over the life of the mortgage. If inflation falls unexpectedly by 3%, what would likely happen to a homeowner with an adjustable-rate mortgage?

Review Questions

11 . How do economists use a basket of goods and services to measure the price level? 12 . Why do economists use index numbers to measure the price level rather than dollar value of goods? 13 . What is the difference between the price level and the rate of inflation? 14 . Why does “substitution bias” arise if we calculate the inflation rate based on a fixed basket of goods? 15 . Why does the “quality/new goods bias” arise if we calculate the inflation rate based on a fixed basket of goods? 16 . What has been a typical range of inflation in the U.S. economy in the last decade or so? 17 . Over the last century, during what periods was the U.S. inflation rate highest and lowest? 18 . What is deflation? 19 . Identify several parties likely to be helped and hurt by inflation. 20 . What is indexing? 21 . Name several forms of indexing in the private and public sector.

Critical Thinking Questions

22 . Inflation rates, like most statistics, are imperfect measures. Can you identify some ways that the inflation rate for fruit does not perfectly capture the rising price of fruit? 23 . Given the federal budget deficit in recent years, some economists have argued that by adjusting Social Security payments for inflation using the CPI, Social Security is overpaying recipients. What is their argument, and do you agree or disagree with it? 24 . Why is the GDP deflator not an accurate measure of inflation as it impacts a household? 25 . Imagine that the government statisticians who calculate the inflation rate have been updating the basic basket of goods once every 10 years, but now they decide to update it every five years. How will this change affect the amount of substitution bias and quality/new goods bias? 26 . Describe a situation, either a government policy situation, an economic problem, or a private sector situation, where using the CPI to convert from nominal to real would be more appropriate than using the GDP deflator. 27 . Describe a situation, either a government policy situation, an economic problem, or a private sector situation, where using the GDP deflator to convert from nominal to real would be more appropriate than using the CPI. 28 . Why do you think the U.S. experience with inflation over the last 50 years has been so much milder than in many other countries? 29 . If, over time, wages and salaries on average rise at least as fast as inflation, why do people worry about how inflation affects incomes? 30 . Who in an economy is the big winner from inflation? 31 . If a government gains from unexpected inflation when it borrows, why would it choose to offer indexed bonds? 32 . Do you think perfect indexing is possible? Why or why not?

Problems

33 . The index number representing the price level changes from 110 to 115 in one year, and then from 115 to 120 the next year. Since the index number increases by five each year, is five the inflation rate each year? Is the inflation rate the same each year? Explain your answer. 34 . The total price of purchasing a basket of goods in the United Kingdom over four years is: year 1=£940, year 2=£970, year 3=£1000, and year 4=£1070. Calculate two price indices, one using year 1 as the base year (set equal to 100) and the other using year 4 as the base year (set equal to 100). Then, calculate the inflation rate based on the first price index. If you had used the other price index, would you get a different inflation rate? If you are unsure, do the calculation and find out. 35 . Within 1 or 2 percentage points, what has the U.S. inflation rate been during the last 20 years? Draw a graph to show the data. 36 . If inflation rises unexpectedly by 5%, indicate for each of the following whether the economic actor is helped, hurt, or unaffected: a. A union member with a COLA wage contract b. Someone with a large stash of cash in a safe deposit box c. A bank lending money at a fixed rate of interest