Chapter 24 : Measuring the Cost of Living

Question 1

Consumer price index

Answer 1

a measure of overall cost of G and S bought by a typical consumer
CPI = (cost of current-year basket/cost of base-year basket) × 100

Question 2

Inflation rate

Answer 2

The percent change in a price index

Question 3

Basket (of goods and services)

Answer 3

The quantities of each item purchased by the typical

consumer

Question 4

Base year

Answer 4

The benchmark year against which other years are compared

Question 5

Bureau of Labor Statistics

Answer 5

The government agency responsible for tracking prices

Question 6

Producer price index

Answer 6

The ratio of the value of a fixed basket of goods and services purchased by firms to the basket’s value in the base year multiplied by 100

Question 7

Cost of living

Answer 7

The income necessary to maintain a constant standard of living

Question 8

Substitution bias

Answer 8

The inability of the CPI to account for consumers’ substitution toward relatively cheaper goods and services

Question 9

Indexed contract

Answer 9

A contract that requires that a dollar amount be automatically corrected for inflation

Question 10

Cost-of-living allowance (COLA)

Answer 10

An automatic increase in income in order to maintain a constant standard of living

Question 11

Nominal interest rate

Answer 11

The interest rate uncorrected for the effects of inflation

Question 12

Real interest rate

Answer 12

The interest rate corrected for the effects of inflation

Question 13

What is the process of calculating a CPI ? (5 steps)

Answer 13

Fix basket=>Find prices=>Compute basket’s cost

=>Choose a base year and compute index=>Compute inflation

Question 14

There are 3 problems with using CPI to measure changes in cost of living.

(a) ____: CPI fails to acknowledge consumer’s substitution of less for more expensive products.
(b) ____: CPI does not reflect the increase(reduction) in purchasing power of dollar
(c) ____: CPI does not reflect the increase(reduction) in quality of good
(b) and (c) => the change in value of a dollar even if actual prices are constant

Answer 14

(a) Substitution bias
(b) Introduction of new goods
(c) Unmeasured quality change

Question 15

(a)____ => 3 problems with using CPI to measure changes in cost of living.=> (b)____ and (c)____

Answer 15

(a) CPI is based on a fixed consumer basket
(b) CPI overstates the increase in the cost of living
(c) CPI overestimate inflation by about 1 percent/year

Question 16

GDP deflator differs from the CPI in 3 ways:

(a) ____ included in CPI, excluded from GDP deflator
(b) ____ included in GDP deflator, excluded from CPI
(c) ____ CPI uses fixed basket, GDP deflator uses basket of currently G and S => This matters if different prices are changing by different amount

Answer 16

(a) Imported consumer goods
(b) Capital goods
(c) The basket

Question 17

• When a dollar amount is automatically adjusted for inflation, it is said to have been (a)____ for inflation.
• A contract with this provision is said to contain b)____

Answer 17

(a) indexed

(b) COLA or cost-of-living allowance

Question 18

How do economists use CPI to correct dollar figures ? (EX: income, interest rate)

Answer 18

Value in year X dollars =

Value in year Y dollars × (CPI in year X/CPI in year Y)

Question 19

What is the formula for correcting nominal interest rate for inflation ?

Answer 19

real interest rate = nominal interest rate – inflation rate