Chapter 6 Flashcards
What does the inflation rate measure?
The percentage change in the price level from the previous period.
How is CPI calculated in numerical terms?
CPI = (Cost of basket in current year / Cost of basket in base year) × 100.
What is core inflation?
Core inflation measures underlying inflation trends, excluding volatile items like food and energy.
Why are CPI and GDP deflator sometimes different?
CPI includes imported goods; GDP deflator includes only domestically produced goods.
CPI uses a fixed basket; GDP deflator changes with the composition of GDP.
What are the components of the CPI basket?
Common components include housing, transportation, food, and other goods and services.
Define substitution bias in the context of CPI.
It occurs when consumers replace more expensive goods with cheaper substitutes, but CPI doesn’t account for this change.
If a senior spends 20% of their income on healthcare and healthcare costs rise by 50%, how is their cost of living affected?
The senior’s cost of living increases by 10% (0.20 × 0.50).
Explain ‘unmeasured quality change’ in CPI.
When product quality improves, the real value of money increases, but CPI may not fully adjust for this improvement.
What is indexation commonly used for?
Adjusting wages, pensions, and taxes to reflect changes in the cost of living.
What is bracket creep?
When inflation increases nominal incomes, pushing taxpayers into higher tax brackets, raising their tax burden without real income growth.
How do changes in the prices of imports affect CPI and GDP deflator?
CPI: Affected since imports are included in the consumer basket.
GDP deflator: Not affected as it includes only domestically produced goods and services.
How does a 10% increase in chicken prices versus caviar prices affect CPI? Why?
Chicken affects CPI more because it constitutes a larger share of the average consumer’s basket.
What happens to borrowers and lenders if inflation is higher than expected?
Borrowers gain as they repay loans with less valuable dollars.
Lenders lose as the real interest rate is lower than expected.
How is the real income calculated?
Real income = Nominal income × (Base year CPI / Current year CPI).
What are some shortcomings of using CPI to measure the cost of living?
Substitution bias.
Exclusion of new goods.
Difficulty in measuring quality improvements.
If nominal GDP is $1,320 and real GDP is $980, what is the GDP deflator?
GDP deflator = (Nominal GDP / Real GDP) × 100 = (1320 / 980) × 100 = 134.7.
How does the CPI overstate cost-of-living increases?
By not reflecting substitution, new goods, or quality changes accurately, it overestimates the impact of inflation on consumers.
What happens when a domestic producer raises prices on exports?
GDP deflator rises.
CPI remains unaffected.
Calculate the inflation rate if CPI in Year 1 = 100 and CPI in Year 2 = 150.
Inflation rate = [(150 - 100) / 100] × 100 = 50%.
What does ‘real interest rate’ signify?
The rate of growth in purchasing power after adjusting for inflation.
What is the main purpose of measuring the overall price level in the economy?
To compare dollar figures across different periods.
What is the Consumer Price Index (CPI)?
A measure of the overall cost of goods and services bought by a typical consumer.
What are the five steps to compute the CPI?
Determine the basket.
Find the prices of the goods in the basket.
Compute the basket’s cost at different times.
Choose a base year and compute the index.
Compute the inflation rate.
What is the formula to calculate the inflation rate?
Inflation rate = [(CPI in current year - CPI in previous year) / CPI in previous year] × 100.
Differentiate between nominal and real interest rates.
Nominal interest rate: The rate reported without adjusting for inflation.
Real interest rate: Nominal interest rate minus inflation rate.
List the three problems that make CPI an imperfect measure of the cost of living.
Substitution bias: Consumers switch to cheaper alternatives, which CPI doesn’t reflect.
Introduction of new goods: CPI’s fixed basket may exclude new items, undervaluing consumer choice.
Unmeasured quality changes: Quality improvements or deteriorations may not be fully captured.
What is ‘indexation’?
The automatic correction of a dollar amount for the effects of inflation by law or contract.
How does CPI differ from the GDP deflator?
CPI: Reflects prices of goods and services bought by consumers, using a fixed basket.
GDP deflator: Reflects prices of all goods and services produced domestically, adjusting dynamically with production.
If the nominal interest rate is 7% and inflation is 5%, what is the real interest rate?
Real interest rate = 7% - 5% = 2%.
Why does CPI overstate inflation?
CPI assumes a fixed basket and doesn’t account for substitution, new goods, or quality changes, leading to overestimated cost increases.
What happens if the price of a domestically produced good rises? How are CPI and GDP deflator affected?
CPI is affected if the good is in the consumer basket.
GDP deflator always reflects the price change as it includes all domestically produced goods.
What is the formula for the Consumer Price Index (CPI)?
CPI = (Cost of basket in current year / Cost of basket in base year) × 100.
How is the Inflation Rate calculated?
Inflation Rate = (CPI in current year - CPI in previous year) / CPI in previous year × 100.
What is the formula to calculate Real Income?
Real Income = Nominal Income × (Base Year CPI / Current Year CPI).
How do you adjust dollar values for inflation between two years?
Value in Year 2 Dollars = Value in Year 1 Dollars × (Price Level in Year 2 / Price Level in Year 1).
What is the formula for the Real Interest Rate?
Real Interest Rate = Nominal Interest Rate - Inflation Rate.
How do you calculate the GDP Deflator?
GDP Deflator = (Nominal GDP / Real GDP) × 100.
How is the cost of the basket of goods calculated (used in CPI)?
Cost of Basket = ∑(Price of Good × Quantity of Good).
How do you calculate the inflation rate if you know the CPI in two different years?
Inflation Rate = (CPI in Year 2 - CPI in Year 1) / CPI in Year 1 × 100.
