Week 15 - Inflation Flashcards
1
Q
What is the consumer price index (CPI)?
A
is a measure of the cost of living during a particular period
2
Q
What does CPI measure?
A
The cost of a standard basket of goods and services in a given year
Relative to the cost of the same basket of goods and services in the base year
Base year changes periodically
3
Q
What is the base year?
A
The base year is a reference point, and the cost of the basket in this year is set to 100. If the CPI in another year is higher than 100, it means that the cost of living has increased (inflation). Conversely, if it’s below 100, it suggests deflation.
4
Q
How is CPI calculated?
A
the ratio of the cost of the basket of goods in the current year to the cost
in the base year
CPI = (Cost of basket in current year/ Cost of basket in base year) x 100
5
Q
CPI calculation example:
Base year cost $940
2020 cost $1,175
A
CPI = (1,175 / 940) x 100 = 1.25
CPI for 2020 is 125, which indicates that the cost of the basket of goods and services is 25% higher in 2020 compared to the base year
6
Q
How do you construct a CPI?
A
Consumer Expenditure Survey: To create a CPI, you must first conduct a survey to determine what consumers typically buy, forming a “basket” of goods and services.
Base Year: Choose a base year for comparison.
Measure Prices: Measure the prices of the goods and services in the basket during both the base year and the current year to calculate the CPI.
7
Q
What does a price index measure?
A
measures the average price of a set of goods and services relative to the price of those same goods in a base year
8
Q
What is a type of price index?
A
CPI which measures the average change in consumer prices over time for a fixed basket of goods and services
9
Q
What are 3 other types of price indices?
A
- Core inflation
- Producer price index (PPI)
- Import/ Export price index
10
Q
What is core inflation?
A
essentially the CPI minus food and energy prices.
These two categories are excluded because they tend to fluctuate a lot due to external factors (e.g., oil prices or weather affecting food production). Core inflation helps economists focus on the long-term trend of price changes without those volatilities.
11
Q
What does producer price index (PPI) measure?
A
measures the average change over time in the prices that producers receive for their goods and services.
It tracks prices at the wholesale or producer level, which can give early signs of inflation before it hits consumers.
12
Q
What do import/ export price index track?
A
These indices track the prices of imported and exported goods.
The Import Price Index measures how much prices for imported goods change, and the Export Price Index tracks price changes for goods sold abroad.
13
Q
Specific things to remember for CPI and price index
A
A CPI is not itself the price of a specific good or service; it is a price index
A price index measures the average price of a class of goods or services relative to the price of some goods in a base year
14
Q
What is inflation?
A
refers to the general increase in the price level of goods and services over time, leading to a decrease in the purchasing power of money.
It means that, on average, consumers will need more money to buy the same goods or services as time goes on
15
Q
What is the rate of inflation?
A
the annual percentage change in the price level, often measured using the Consumer Price Index (CPI) or other price indices
16
Q
What is deflation?
A
when the general price level of most goods and services falls over time, leading to negative inflation
17
Q
How do you calculate the rate of inflation?
A
Rate of inflation = (CPI in current year - CPI in previous year) x 100
This tells us how much prices have increased (or decreased) compared to the previous year
18
Q
What is nominal quantity?
A
is measured in current dollars, meaning it reflects the value at today’s prices. It doesn’t account for inflation or changes in price levels over time.
Example: If you earned $50,000 in 2020, that’s your nominal income.
19
Q
What is real quantity?
A
is adjusted for inflation and reflects the value in terms of physical goods and services, or constant purchasing power. It removes the effects of price level changes, allowing for a true comparison over time.
Example: If your income in 2020 was $50,000, but inflation increased the cost of living by 2%, the real income would show how much you could actually buy with that income after adjusting for inflation.
20
Q
How do we adjust for inflation (deflation)?
A
Deflating a Nominal Quantity involves dividing the nominal value by a price index to convert it to real terms. This adjustment helps account for how inflation (or deflation) has altered the value of money over time.
21
Q
What is a real wage?
A
refers to the wage that a worker is paid, adjusted for inflation. It shows how much a worker can actually purchase with their earnings.
22
Q
What is the nominal wage?
A
the wage paid in current dollars (the actual amount of money earned)
23
Q
How do you calculate real wages?
A
Real wage = (Nominal wage/ CPI) x 100
24
Q
What is indexing?
A
refers to increasing a nominal quantity each period based on the percentage increase in a specific price index (often the Consumer Price Index (CPI)).
25
What is the goal of indexing?
The goal is to ensure that the purchasing power of the nominal quantity (like wages, benefits, or pensions) is maintained over time, despite inflation.
26
How does indexing work?
when an amount is indexed to inflation, it is adjusted automatically in proportion to the percentage change in the price index.
This prevents inflation from eroding the value of that amount.
Example: If a Social Security payment is indexed to the CPI and prices rise by 3%, the payment will automatically increase by 3% in the next year, ensuring that recipients can maintain their purchasing power.
27
Examples of indexing:
Social Security Payments:
In the U.S., Social Security benefits are often indexed to inflation.
If the CPI increases by 3% in a given year, Social Security recipients will receive a 3% increase in their payments. This adjustment keeps the value of the payments in line with the cost of living.
Automatic Adjustments: These adjustments happen automatically without needing legislative action, although Congress can sometimes alter how indexing is applied.
Labor Contracts:
Some labor unions include indexing clauses in their contracts to ensure that wages automatically adjust in line with inflation.
For example, if a worker’s salary is tied to the CPI and inflation is 4%, their salary will increase by 4%, maintaining their real wage (purchasing power).
28
Example: indexed labour contract
Contract Terms:
Year 1 wage = €12/hour
Real wage increase = 2% each in Year 2 and Year 3.
CPI Values:
Year 1 = 1.00 (base year)
Year 2 = 1.05 (a 5% increase from Year 1)
Year 3 = 1.10 (a 5% increase from Year 2)
Y2 wage:
Calculate the Real Wage Increase:
Real wage increase for Year 2 = 2%
Multiply the Year 1 wage by 1.02 to reflect the 2% real wage increase:
Year 2 wage = w_2/ 1.05 = €12 x 1.02 = €12.24
Adjust for Inflation (CPI for Year 2 is 1.05):
Divide the nominal wage by the CPI (1.05) and then multiply by the inflation-adjusted real wage
w_2 = €12.24 X 1.05 = €12.85
The Year 2 wage = €12.85/hour
Y3 wage:
Calculate the Real Wage Increase:
Real wage increase for Year 3 = 2%
Multiply the Year 2 wage by 1.02
Year 3 wage = w_3/1.10 = 12.24 x 1.02 = €12.48
Adjust for Inflation (CPI for Year 3 is 1.10):
Divide the nominal wage by the CPI (1.10) and then multiply by the inflation-adjusted real wage:
w_3 = €12.48 X 1.10 = €13.73
The Year 3 wage = €13.73/hour
29
Who is minimum wage set by?
by Congress in nominal terms, meaning it’s not automatically adjusted for inflation.
30
What does setting minimum wage cause?
This results in public debates and decisions regarding increases, often influenced by political discussions around fairness, economic growth, and workers' rights
31
Why does indexing the minimum wage to a price index (such as the Consumer Price Index (CPI)) make the process simpler and less controversial?
Automatic Adjustments: The wage would rise automatically with inflation, without needing frequent political action or debates.
Predictability: Workers and businesses would have a clearer understanding of wage changes over time, based on inflation rates.
Reduced Political Debate: Indexing removes the need for regular debates on whether or not to increase the minimum wage, which can be politically contentious
32
Have the nominal and real minimum wage both increased?
The nominal minimum wage has risen significantly over the years, but when adjusted for inflation, the real minimum wage has actually decreased by about 30% since 1970
the increase in the nominal minimum wage hasn’t kept up with the inflation rate, meaning workers earning the minimum wage today have less purchasing power than workers did in 1970, despite nominal wage increases
33
Why does increasing the minimum wage contribute to inflation?
Higher Labor Costs: When companies are forced to pay workers more, they often pass on those increased costs to consumers in the form of higher prices for goods and services.
Cost-Push Inflation: This is a type of inflation that occurs when the cost of production increases (e.g., due to higher wages), and businesses raise prices to maintain profit margins.
34
How are economists divided on the actual impact of minimum wage increases on inflation?
Moderate Increases: Some economists argue that moderate increases in the minimum wage may have a negligible effect on inflation, especially if the increase is small relative to the overall economy.
Small Increases: Others believe that even small increases in the minimum wage could have a significant impact on prices, especially in sectors that rely heavily on minimum wage workers (such as retail and hospitality).
35
What is a tight labour market?
A tight labour market refers to a situation where there is:
Low unemployment: A high percentage of the workforce is employed.
High job vacancies: There are more job openings than there are workers available to fill them.
36
What must employers do in a tight labour market?
Employers compete for a limited number of workers.
Workers have more bargaining power because they can choose between multiple job opportunities.
37
What is the impact of a tight labour market on wages and salaries?
In a tight labour market, employers are forced to increase wages and offer better benefits to attract and retain workers.
As wages rise, labour costs for employers increase.
Employers often pass these higher labour costs onto consumers in the form of higher prices for goods and services, contributing to inflation.
38
How does a tight labour market increase consumer spending?
As workers earn higher wages, they have more disposable income and are likely to spend more on goods and services.
This increased demand for products and services can push prices up, particularly in industries with higher labour costs (like retail, construction, and hospitality).
Increased consumer demand combined with rising labour costs can create inflationary pressure, leading to price increases.
39
What is an inflationary spiral?
A wage-price inflation spiral can occur in a tight labour market:
Wages rise as employers compete for workers.
These higher wages lead to higher production costs, which companies pass on to consumers as higher prices.
The rising prices lead to increased demand for higher wages, as workers seek to maintain their purchasing power.
The cycle repeats, leading to wage and price inflation.
40
What is the economic strength in a tight labour market?
A tight labour market is often seen as a sign of a strong economy because it indicates that businesses are expanding and hiring.
However, if left unchecked, it can lead to higher inflation and contribute to the wage-price inflation spiral, which can destabilise the economy.
41
How does CPI influence policy changes in relation to inflation?
The CPI is used by policymakers to gauge the rate of inflation, and it often informs critical policy decisions, such as:
Monetary policy: Central banks use CPI data to adjust interest rates and control inflation.
Fiscal policy: Governments may adjust spending and taxation based on inflation trends.
Wage increases: Many wages, including minimum wage and social security benefits, are indexed to inflation (often based on CPI).
42
What 3 reasons may CPI overstate inflation?
1. Government spending
2. Fixed basket of goods
3. Quality adjustments
43
How may CPI overstating inflation influence government spending?
Overstating inflation could lead to increased government spending, especially when inflation-indexed items (like government bonds, public wages, and social benefits) are adjusted based on an inflated CPI.
This could lead to higher debt repayments on inflation-indexed government bonds and increased public wages due to indexation, potentially contributing to higher public debt.
44
How may CPI overstating inflation from the fixed basket of goods?
The CPI is calculated based on a fixed basket of goods and services, which may not reflect the actual consumption patterns of all households.
If the prices of certain goods in the basket rise disproportionately, but consumers switch to cheaper alternatives, the CPI might overstate the actual increase in cost of living.
The fixed basket doesn’t capture substitution effects (where consumers shift to less expensive goods when prices rise).
45
How may CPI overstating inflation account for quality adjustment?
The CPI may not fully account for changes in the quality of goods and services over time.
For example:
Technological improvements: If the price of a product like a smartphone increases, but the new model offers significantly better features, the CPI might treat this as inflation without fully accounting for the increased value.
Improvements in service quality: If the quality of a service (e.g., healthcare or education) improves but costs rise, the CPI might still reflect this as inflation without adjusting for the higher quality provided.
46
What efforts are there to improve CPI?
The Bureau of Labor Statistics (BLS) takes various steps to improve the accuracy of the CPI:
Regular updates to the basket of goods and services to better reflect current consumer spending patterns.
Adjustments for quality changes in products and services.
Efforts to incorporate more accurate measures of substitution effects (for instance, when people buy cheaper goods as prices rise).
Use of alternative indices (like the Core CPI, which excludes volatile items like food and energy) to give a clearer picture of underlying inflation trends.
47
What is the CPI and quality adjustment bias?
One of the key biases in the CPI is that it measures price changes but does not always fully account for quality changes. This means that the CPI may incorrectly reflect price increases for goods that have improved in quality over time
48
What are 2 challenges of adjusting for quality?
1. Large Number of Goods: There are thousands of different goods and services that make up the basket of goods in the CPI. Adjusting for quality across all of them is complex and resource-intensive.
2. Subjective Differences: Determining the exact value added by a quality improvement can be subjective. For example, how much more valuable is a phone with a better camera? Different consumers might have different opinions on the value of such an improvement.
49
Why is incorporating new goods difficult?
The introduction of new goods (e.g., the first smartphone models, new technologies, or entirely new product categories) further complicates CPI calculation:
No base year price: For new products, there’s often no historical price to compare them to. This makes it hard to measure price changes over time, especially when new goods represent substantial improvements over older alternatives.
Price vs. Quality: New goods might be priced higher initially but offer vastly improved features. Without a proper adjustment for the added value, this can lead to an overstatement of inflation.
50
What is substitution bias in CPI?
The CPI assumes that consumers continue to buy the same quantities of goods and services each year, which is based on a fixed basket of goods.
When the price of a good increases, consumers typically buy less of that good and substitute it with a similar, cheaper alternative.
CPI's Fixed Basket: Since the CPI doesn't account for this substitution, it can overstate inflation by assuming that consumers continue to buy the same quantities of goods at higher prices, even though they may have switched to cheaper alternatives.
51
What is the GDP price deflator?
The GDP Price Deflator measures the change in prices for all the goods and services produced in an economy over a specific period.
It helps economists distinguish between nominal GDP (the total economic output measured at current prices) and real GDP (adjusted for inflation). This allows economists to compare the level of economic activity from one year to another without the distortion of inflation.
52
Why is the GDP price deflator more comprehensive than CPI?
Fixed Basket Problem in CPI: The CPI uses a fixed basket of goods and services to measure inflation. This means it doesn't account for changes in consumer behaviour or the introduction of new products.
The GDP Price Deflator is not based on a fixed basket. It automatically adjusts for changes in the composition of goods and services produced in the economy, including new goods and changes in consumption patterns. Therefore, it captures a more accurate picture of overall price changes in the economy.
53
What is the formula for the GDP price deflator?
GDP price deflator = (Nominal GDP/ Real GDP) x 100
This calculation essentially captures how much of the nominal GDP increase is due to price changes (inflation or deflation) versus how much
is due to actual increases in the quantity of goods and services produced.
54
Why is the GDP price deflator important?
GDP represents the total output of goods and services. However, as GDP rises and falls, the metric doesn't factor the impact of inflation or rising
prices into its results.
The GDP price deflator addresses this by showing the effect of price changes on GDP, first by establishing a base year and, secondly, by comparing current prices to prices in the base year.
55
What does an economy experiencing price inflation appear to be doing in dollar terms?
In dollar terms, an economy experiencing price inflation would appear to be growing because the nominal GDP (which is calculated using current prices) will rise, even if there is little-to-no growth in the actual quantity of goods and services produced. The increase is due to higher prices, not increased production.
56
What could happen if the economy is experiencing little-to-no growth but inflation is present?
If the economy is experiencing little-to-no real growth, but there is price inflation, the total output figures (GDP) would appear higher than what is truly being produced. This is because the increase in nominal GDP is due to price rises rather than an actual increase in the quantity of goods and services.
57
How does the GDP Price Deflator help economists identify inflation?
The GDP Price Deflator helps identify inflation by showing how much of the nominal GDP increase is due to price inflation over a specific period, as opposed to increases in real output (the quantity of goods and services produced). It adjusts for price changes to show how much of GDP growth is purely from inflation.
58
What is the CPI and what does it measure?
The Consumer Price Index (CPI) measures the changes in prices for a fixed basket of goods and services typically purchased by consumers. It reflects how changes in prices affect a consumer's cost of living, indicating how much more or less consumers have to spend to purchase the same items over time.
59
What are the limitations of the CPI?
The CPI uses a fixed basket of goods, meaning that it doesn't reflect changes in consumption patterns or include new products that become popular. For example, if consumers start buying smartphones instead of landline phones, the CPI would miss this shift. It may also fail to account for the substitution effect (when consumers switch to cheaper alternatives due to rising prices).
60
Why does the GDP Price Deflator have an advantage over the CPI?
The GDP Price Deflator has an advantage because it isn't based on a fixed basket of goods. It measures price changes for all goods and services produced in the economy, allowing it to automatically capture changes in consumption patterns (e.g., people buying new products or changing preferences) and new goods and services that are introduced into the market.
61
How does the GDP Price Deflator reflect changes in the economy?
The GDP Price Deflator automatically incorporates changes in consumption patterns (e.g., buying more of one type of product and less of another) and the introduction of new goods and services into the economy. This makes it a more comprehensive measure of inflation because it accounts for the broader changes occurring within the entire economy.
62
How are the trends in the GDP Price Deflator and CPI related?
Although the GDP Price Deflator and CPI are calculated differently, their trends are usually similar. Both reflect overall inflation in the economy. However, the deflator provides a broader measure of inflation because it includes changes across all goods and services, while the CPI is focused on consumer goods and services.
63
What is the key difference between the CPI and the GDP Price Deflator?
CPI: Measures inflation based on a fixed basket of goods and services purchased by consumers, reflecting the consumer's cost of living. It does not adjust for changes in the consumption of new goods or shifts in preferences.
GDP Price Deflator: Measures inflation for the entire economy, capturing price changes for all goods and services produced, including new goods and changes in consumption patterns. It is more comprehensive and reflects a dynamic economy.
64
How does the GDP Price Deflator adjust for inflation?
The GDP Price Deflator adjusts for inflation by comparing nominal GDP (current prices) to real GDP (adjusted for inflation). This allows economists to see how much of the increase in nominal GDP is due to price changes (inflation) versus actual increases in the quantity of goods and services produced.
65
What does the price level measure?
The price level is a measure of the overall level of prices in an economy at a particular point in time.
It is often measured using price indexes such as the Consumer Price Index (CPI). It provides a snapshot of inflation, showing how much the cost of goods and services has changed relative to a base year.
66
What is the meaning of relative price?
Relative price refers to the price of a specific good or service in comparison to the prices of other goods and services. For example, if the inflation rate is 2% but the price of light bulbs only increases by 1%, the relative price of light bulbs has decreased by 1% compared to other goods.
67
How does inflation affect relative prices?
When inflation occurs, the relative price of a good can change.
For instance, if inflation is at 2% and the price of light bulbs rises by only 1%, the relative price of light bulbs compared to other goods has decreased. This encourages consumers to look for cheaper substitutes, while businesses may introduce alternatives to attract buyers.
68
Do changes in relative prices imply significant inflation?
Changes in relative prices do not necessarily indicate a significant amount of inflation. Inflation could be high overall, but the relative prices of specific goods might not change much. Inflation can occur without substantial shifts in the prices of individual goods and services relative to each other.
69
Can inflation occur without affecting relative prices?
Yes, inflation can be high without causing relative price changes. This is because inflation might impact the overall price level of the economy, but individual goods and services could experience price changes at different rates. Thus, inflation doesn’t always lead to changes in the relative prices between goods.
70
What would the government need to do to counteract relative price changes?
To counteract relative price changes, the government would need to intervene directly in specific markets. This could involve implementing policies that affect the supply or demand for particular goods or services, influencing their relative prices. However, this is a complex task as prices are influenced by many factors.
71
How can the government counteract inflation in general?
To combat inflation, the government uses monetary and fiscal policies. Monetary policy involves controlling the money supply and interest rates, while fiscal policy focuses on government spending and taxation. Both policies are aimed at either reducing inflation or boosting economic activity when inflation is low.
72
Can relative prices change significantly without inflation changing?
Yes, relative prices can change significantly without corresponding changes in inflation. Prices of certain goods and services fluctuate due to seasonal factors, supply changes, or demand shifts, independent of overall inflation trends.
73
What is an example of seasonal relative price changes?
In summer, prices of beach hotels, cruises, and gas tend to be higher due to increased demand, while fresh fruit, vegetables, and heating oil tend to be lower because they are more abundant or less needed.
74
How does inflation affect relative prices?
Inflation can distort relative prices, making some goods and services appear more expensive or cheaper than they actually are. This misleads consumers and businesses, leading to inefficient resource allocation.
75
How do distorted relative prices impact consumer decisions?
When inflation distorts relative prices, consumers may misallocate spending by purchasing goods that seem cheaper due to inflation effects, rather than those that genuinely offer the best value.
76
How do distorted relative prices affect markets?
Markets become less efficient at allocating resources when inflation distorts prices. Businesses might misjudge demand and overproduce or underproduce certain goods, leading to economic inefficiencies.
77
Why is the U.S. tax system considered complex?
The U.S. tax system has multiple levels of taxation (federal, state, and city), leading to conflicting incentives that can distort economic decisions regarding work, saving, and investment.
78
How does a lack of tax indexing distort economic incentives?
When taxes are not indexed to inflation, individuals may face higher tax burdens even if their real income hasn’t increased. This discourages work, saving, and investment.
79
What is Bracket Creep, and why does it matter?
Bracket Creep happens when inflation raises nominal income, pushing individuals into higher tax brackets even though their purchasing power remains unchanged. This leads to unfairly higher taxes.
80
How does inflation affect savings and investment?
Since income tax applies to nominal interest (not adjusted for inflation), part of the taxed income is just compensation for inflation. This reduces the real after-tax return, making saving less attractive.
81
What is the connection between savings, investment, and economic growth?
Lower savings and investment result in slower capital accumulation, reducing economic growth and limiting business expansion, innovation, and job creation.
82
What happens to cash when there is no inflation?
When inflation is zero, cash holds its value over time, making it convenient for transactions and savings.
83
How does inflation affect the value of cash?
When inflation is high, cash loses value over time, meaning that the same amount of money buys fewer goods and services.
84
How do consumers and businesses manage cash balances during inflation?
To limit losses from inflation, people make more frequent, smaller withdrawals, which cost time, travel, and effort—a real cost of inflation.
85
How does inflation increase banking costs?
Inflation leads to more transactions as people withdraw cash more often, increasing bank processing costs and inefficiencies.
86
What are "shoe-leather costs" in economics?
"Shoe-leather costs" refer to the time and effort spent making frequent trips to the bank to avoid holding cash that loses value due to inflation. The term comes from the idea of wearing out one’s shoes from walking to the bank often.
87
How does unexpected inflation affect wealth distribution?
Unexpected inflation redistributes wealth by benefiting some economic agents while harming others.
88
What happens when workers' salaries are not indexed and inflation is higher than expected?
Workers' salaries lose purchasing power, meaning they can afford fewer goods and services, while employers gain because they pay wages that are worth less in real terms.
89
How does unexpected inflation affect borrowers and lenders?
Borrowers benefit because they repay loans with money that is worth less than expected. Lenders lose because the real value of the money they receive is lower than anticipated.
90
Why does unexpected inflation confuse incentives?
It makes it harder for businesses, workers, and investors to plan for the future, leading to inefficiencies and economic uncertainty.
91
How does erratic inflation affect long-term decision-making?
Erratic inflation makes planning risky, as individuals and businesses cannot accurately predict future costs and incomes.
92
Why is inflation a concern for retirement planning?
Inflation affects the cost of living in the future, making it difficult to estimate how much money is needed for retirement.
93
What are the risks of miscalculating inflation when saving for retirement?
Save too little: Risk of lower living standards in retirement.
Save too much: Lower quality of life now due to excessive saving.
94
Why do most economists prefer low and stable inflation?
Low and stable inflation reduces uncertainty, making long-term financial planning and investment more reliable and supporting a healthy economy.
95
What are menu costs?
Menu costs refer to the costs of adjusting prices during inflationary periods, including updating price lists, reprinting menus, and changing price tags.
96
Why are menu costs considered a real cost of inflation?
Adjusting prices requires resources (time, labor, materials), taking away from more productive activities in a business.
97
What does it mean for prices to be sticky?
Prices do not always adjust immediately to changes in the economy; they may remain fixed for some time due to contracts, market power, or adjustment costs.
98
How did sticky prices affect inflation during 2022-2023?
Despite high interest rates after the pandemic, prices did not decrease significantly due to long-term contracts and businesses’ ability to maintain prices (market power).
99
How does unanticipated inflation affect borrowers and lenders?
Unanticipated inflation helps borrowers (since they repay loans with money that has less purchasing power) and hurts lenders (since they receive payments worth less than expected).
100
What is the real interest rate, and how is it different from the nominal interest rate?
The real interest rate is the annual increase in purchasing power of financial assets, while the nominal interest rate is the annual increase in dollar value of an asset.
101
What is the Fisher Equation?
The Fisher Equation calculates the real interest rate:
Real interest rate (r) = Nominal interest rate (i) – Inflation rate (π)
r = i - π
102
Why are nominal interest rates more commonly stated than real interest rates?
Nominal interest rates are easier to observe because they do not adjust for inflation, making them the standard rate reported by banks and lenders.
103
104
How does unexpected inflation impact borrowers and lenders?
Unexpected inflation benefits borrowers (who repay loans with money worth less) and hurts lenders (who receive payments with lower real value).
105
How does inflation affect the real interest rate when the nominal interest rate is fixed?
For a given nominal interest rate, a higher inflation rate results in a lower real interest rate.
106
Why might expected inflation not harm lenders?
Lenders can adjust nominal interest rates to account for inflation, ensuring they still earn a fair return.
107
What are inflation-protected bonds, and how do they work?
Inflation-protected bonds pay a real interest rate plus the inflation rate, protecting investors from inflation’s impact.
108
What is the Fisher effect?
The Fisher effect states that nominal interest rates tend to be high when inflation is high and low when inflation is low.
109
How does increased government spending lead to demand-pull inflation?
When the government increases spending, demand for goods and services rises. If supply cannot keep up, prices increase, leading to demand-pull inflation.
110
How can government borrowing or printing money cause inflation?
Government borrowing or printing money increases the money supply, which can decrease the value of money and lead to monetary inflation.
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