Self-Check Questions

degree—for example, by allowing the basket of goods to evolve over time—but we cannot totally eliminate them. The most commonly cited measure of inflation is the Consumer Price Index (CPI), which is based on a basket of goods representing what the typical consumer buys. The Core Inflation Index further breaks down the CPI by excluding volatile economic commodities. Several price indices are not based on baskets of consumer goods. The GDP deflator is based on all GDP components. The Producer Price Index is based on prices of supplies and inputs bought by producers of goods and services. An Employment Cost Index measures wage inflation in the labor market. An International Price Index is based on the prices of merchandise that is exported or imported.

9.3 How the U.S. and Other Countries Experience Inflation

In the U.S. economy, the annual inflation rate in the last two decades has typically been around 2% to 4%. The periods of highest inflation in the United States in the twentieth century occurred during the years after World Wars I and II, and in the 1970s. The period of lowest inflation—actually, with deflation—was the 1930s Great Depression.

9.4 The Confusion Over Inflation

Unexpected inflation will tend to hurt those whose money received, in terms of wages and interest payments, does not rise with inflation. In contrast, inflation can help those who owe money that they can pay in less valuable, inflated dollars. Low rates of inflation have relatively little economic impact over the short term. Over the medium and the long term, even low rates of inflation can complicate future planning. High rates of inflation can muddle price signals in the short term and prevent market forces from operating efficiently, and can vastly complicate long-term savings and investment decisions.

9.5 Indexing and Its Limitations

A payment is indexed if it is automatically adjusted for inflation. Examples of indexing in the private sector include wage contracts with cost-of-living adjustments (COLAs) and loan agreements like adjustable-rate mortgages (ARMs). Examples of indexing in the public sector include tax brackets and Social Security payments.

Self-Check Questions

1 . Table 9.4 shows the fruit prices that the typical college student purchased from 2001 to 2004. What is the amount spent each year on the “basket” of fruit with the quantities shown in column 2? (2001) Amount (2002) Amount (2003) Amount (2004) Amount Items Qty (2001) (2002) (2003) (2004) Price Price Price Price Spent Spent Spent Spent Apples 10 $0.50 $0.75 $0.85 $0.88 Bananas 12 $0.20 $0.25 $0.25 $0.29 Grapes 2 $0.65 $0.70 $0.90 $0.95 Raspberries 1 $2.00 $1.90 $2.05 $2.13 $2.13 Total TABLE 9.4 2 . Construct the price index for a “fruit basket” in each year using 2003 as the base year. 3 . Compute the inflation rate for fruit prices from 2001 to 2004. 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?