Lecture 30: Measuring the Cost of Living 1 and 2

Question 1

What is inflation?

Answer 1

a rise of average prices through the economy

Question 2

What is deflation?

Answer 2

a fall in the average prices through the economy

Question 3

How can we measure inflation?

Answer 3

using the Consumer Price Index

Question 4

What is one issue with using the CPI to measure inflation?

Answer 4

it tends to overstate what is happening so if the CPI says there is 0 inflation, there is probably deflation

Question 5

What is the target for inflation?

Answer 5

between 1-3%

Question 6

What is the CPI?

Answer 6

this measures the overall cost of a “basket” of goods and services bought by a typical household

Question 7

What does CPI measure?

Answer 7

it measures changing purchasing costs of a fixed basket of goods and services

Question 8

What does the basket (what the CPI measures) represent?

Answer 8

the average expenditure pattern of NZ households at the index base period

Question 9

How often is the “basket” reviewed?

Answer 9

every three years

Question 10

Just because the basket is more expensive, doesn’t mean what?

Answer 10

that everything inside the basket is more expensive

Question 11

What 5 things is CPI is used as?

Answer 11

1. a measure of inflation
2. an indicator for monitoring economic and monetary policy
3. an indicator of the effect f price change on the purchasing power or household incomes
4. as a means to adjust benefits, allowances and incomes
5. as a price deflator

Question 12

If wages go up faster than the price of goods, are workers better or worse off?

Answer 12

better off

Question 13

How can we calculate the CPI?

Answer 13

price x quantity for each item in the basket and then add those together then multiply those by 1000
select a base year then do [(final - initial)/initial] x 100

Question 14

What are four uses for the CPI?

Answer 14

• a measure of aggregate price level in the economy
• measure change on the cost of living
• to estimate how much income needs to raise to maintain a constant standard of living
• to evaluate how much standard of living has eroded

Question 15

What are 5 problems with CPI?

Answer 15

1. substitution bias
2. the introduction of new goods
3. doesn’t take into account quality changes
4. there could be comparing eras
5. indexation

Question 16

What is substitution bias in terms of problems with the CPI?

Answer 16

• not all prices rise proportionately, some rise more than others and some even fall
• consumers substitute to goods and services that are relatively cheaper
• therefore the index will overstate increases in the cost of living
  Inside the basket there are substitutes for each other. If one becomes more expensive, you move to another one but it is not reflected in the basket for 3 years so it is overstating the increase. There is a matura tendency of the basket to exaggerate inflation because it puts more importance on things that went up in price than what is really true. We can’t adjust the basket for every substitution so there is a bias in favour of more expensive stuff which makes them more important that what they would normally be and this exaggerates the measurement

Question 17

What is the introduction of new goods a problem with the CPI?

Answer 17

• an introduction of new goods increases the variety of goods consumed which rendered each dollar more valuable
• it should show as a decrease in the index due to greater purchasing power of each dollar
• subsequent index calculation take into account changes in price of such items - but impact at introduction is not incorporated
  something new might come in but it won’t be reflected in the basket for next three years

Question 18

Why are unmeasured quality changes a problem with CPI?

Answer 18

• if the quality of a good or service rises then the value of each dollar rises
• if the quality of a good or service falls then the value of each dollar falls
• while the price of a good or service can be adjusted in the face of changed in the quality and such changes are hard to measure
  the price might stay the same but the quality might increase but this cant be measured

Question 19

What are comparing eras when looking at problems with CPI?

Answer 19

to see if someone is better off:

• (wage of a year/quantity of that year) x 1000
• do that for each year and see which one is higher

Question 20

What is the CPI of the base year?

Answer 20

1000

Question 21

Why is indexation a problem with CPI?

Answer 21

some people have contracts that have, built into the contract, that your wage will keep up with inflation

Question 22

Give an example of the fisher effect

Answer 22

If you put $100 in the bank and the interest rate is 10% so at the end of the year you would have $110. However, if the inflation rate was 4%, you would need $104 at the end of the year to buy what you could at the start of the year. Therefore you only get 6% return not 10%

Question 23

Real interest rate =

Answer 23

nominal interest rate - inflation rate

Question 24

If a loan of $10,000 is to be repaid in five years plus interest costs of $5000 then the total repayment is $15,000. If you salary rises with inflation, you $15,000 repayment as a proportion of your salary will depend on the inflation rate. What will this mean if there is inflation and what will it mean if there is deflation?

Answer 24

• if there is inflation, you will repay the loan will less valuable dollars (which is good for the borrower)
• if there is deflation, you will repay the load with more valuable dollars (which is bad for the borrower)

Question 25

What is the inflation fallacy?

Answer 25

inflation erodes the purchasing power of a dollar but not necessarily if all prices and wages are changing in the same way

Question 26

Inflation does not mean

Answer 26

everything is more expensive

Question 27

Why does inflation not mean everything is more expensive? (ie. the inflation tax cost of inflation)

Answer 27

When all prices rise (including the price of wages), buyers pay more for goods and services but sellers (and workers) also receive more

Question 28

Inflation in itself does not reduce

Answer 28

purchasing power

Question 29

What are seven costs of inflation?

Answer 29

inflation tax
shoe leather costs
menu costs
relative price variability
inflation induces tax distortions
confusion and inconvenience
arbitrary redistribution of wealth

Question 30

Describe the shoe leather costs of inflation

Answer 30

Resources are wasted when inflation encourages people to reduce their money holdings. People keep less money on hand than if there is no inflation. The effect can be substantial during periods of very high inflation

Question 31

Describe the menu costs of inflation

Answer 31

This looks at the costs of changing prices. It includes the cost of deciding new prices, printing new price lists and advertising new prices. During periods of high inflation, firms must change prices regularly

Question 32

Describe the relative price variability cost to inflation

Answer 32

This describes a loss in efficiency when inflation is either unanticipated of where menu costs imply infrequent price changes. Firms may change prices at different times, which would distort relative prices. Market economies rely on relative prices to allocate scarce resources. Unanticipated inflation will also increase consumer search effort

Question 33

Describe how inflation induces tax distortion

Answer 33

it raises the tax burden on income from savings
If workers wages go up due to inflation (in the contract) then they pay be pushed up into another tax bracket which means that they would be no better off (they would be worse off as they are paying more tax off)

Question 34

Describe the confusion and inconvenience cost of inflation

Answer 34

the inflation rate is usually more volatile in periods of high inflation which means it is more difficult for people to distinguish between a relative price change and a general price change

Question 35

Describe the arbitrary redistribution of wealth cost of inflation

Answer 35

Unexpected inflation redistributes wealth not on the base of either merit or need. An increase in the inflation rate redistributes income from lenders to borrowers. A decrease in the inflation rate