Week 5

Question 1

what is price level, inflation and inflation rate

Answer 1

§Price level: A measure of the average prices of goods and services in the economy.
§Inflation: The sustained increase in the general level of prices in the economy.
§Inflation rate: The percentage increase in the general price level in the economy from one year to the next.

Question 2

Consumer price index (CPI):

Answer 2

§The CPI is the most widely used measure of inflation.

§: A measure of changes in retail prices of a basket of goods and services representative of consumption expenditure by typical Australian households in capital cities.

Question 3

what the ABS’s role in terms of CPI

Answer 3

§The Australian Bureau of Statistics (ABS) surveys households on their spending habits.
–The goods and services typically purchased by households is the ‘market basket’.
–The prices of goods and services in the market basket are given a weight according to their fraction of a ‘typical’ family budget.

Question 4

The CPI measures

Answer 4

measures the rate of change in the prices of the goods and services in the market basket

Question 5

Answer 5

Find the 2016 inflation rate

Question 6

Four sources of bias in the CPI may lead to it overstating the inflation rate

Answer 6

–Substitution bias
–Increase in quality bias
–New product bias
–Outlet bias

Question 7

measuring inflation

The producer price index (PPI):

Answer 7

§: An average of the prices received by producers of goods and services at all stages of the production process.
§Like the CPI, the PPI tracks the prices of a market basket of goods.

Question 8

calculate the inflation rate

Answer 8

CPI = expenditures in current yr/ expenditures in base yr x 100

CPI in 2011 = 314/314 x 100 = 100

CPI in 2015= 360/314 x 100 = 114.65

Inflation rate = CPI in current yr- CPI in base yr/ 100 x 100 = 114.65-100/100 x 100=

Question 9

what happens to purchasing power when prices rise

Answer 9

The purchasing power of the dollar falls

Question 10

Price indexes, such as the CPI, enable

Answer 10

§adjustments to be made for the effects of inflation, so dollar values can be compared over time.

Question 11

The 2013 purchasing power equivalent of a $20 000 salary in 1980 can be found

Answer 11

Question 12

Nominal interest rate and real interest rate

Answer 12

§The stated interest rate on a loan.
§Real interest rate: The nominal interest rate minus the inflation rate.

Question 13

If the inflation rate is higher than expected

Answer 13

borrowers may gain and lenders receive a lower real interest rate (on a fixed interest rate loan).

Question 14

The real interest rate provides a better measure of

Answer 14

§the true cost of borrowing and the true return to lending than does the nominal interest rate.

Question 15

It is possible for the nominal interest rate to be less than the real interest rate when

Answer 15

there’s deflation - rare in australia

Question 16

When the inflation rate is high, the gap between nominal and real interest rates

Answer 16

often becomes large

Question 17

Does inflation impose costs on the economy?

Answer 17

Nominal incomes generally rise with inflation

§For the ‘average’ person, nominal wages increase with inflation.

Question 18

Inflation and the distribution of income

what happens to people on fixed incomes

Answer 18

§People on fixed incomes are likely to experience reduced purchasing power due to inflation.

Question 19

INflation and distribution of income

what does the extent of distribution depend on

Answer 19

§degree to which inflation is anticipated or unanticipated.

Question 20

does inflation pose costs on the economy

Problems with anticipated inflation

Answer 20

§Income redistribution, as some people’s income will fall behind anticipated inflation.
§For those holding wealth in paper money.

Question 21

does inflation pose costs on the economy

Problems with anticipated inflation

menu costs?

Answer 21

Menu costs: The costs to firms of changing prices

Question 22

does inflation pose costs on the economy

Problems with anticipated inflation

taxes?

Answer 22

Increases taxes paid by those who own income generating assets, such as bonds, shares and deposits, and also increases personal income taxes paid due to ‘bracket creep

Question 23

Problems with unanticipated inflation

Answer 23

There are winners and losers, depending on whether inflation is higher or lower than anticipated

Question 24

Problems with unanticipated inflation

those with fixed incomes?

Answer 24

–For example: Those on fixed incomes will lose if inflation is higher than anticipated.

Question 25

Problems with unanticipated inflation

Borrowers and lenders?

Answer 25

–Borrowers on fixed-term contracts may gain and lenders may lose when inflation is higher than anticipated.

Question 26

Problems with unanticipated inflation

contracts?

Answer 26

–People on fixed-payment contracts will lose if inflation is higher than anticipated.

Question 27

Hyperinflation

Answer 27

Extremely rapid increases in the general price level.

Question 28

what happens In periods of hyperinflation

Answer 28

–money loses value so rapidly that firms and households try to avoid holding it.

Question 29

Hyperinflation is often associated with

Answer 29

–political instability and usually accompanied by a severe recession and economic and political turmoil.

Question 30

Deflation:

Answer 30

A decline in the general price level in the economy.

Question 31

problems with deflation include

Answer 31

1. Increases debt burdens
2. Reduces asset values and wealth
3. Gains to consumers from falling prices may be negated by falling wages
4. The real interest rate rises above the nominal interest rate, discouraging business borrowing and reducing the effectiveness of monetary policy
5. Long-term deflation can severely erode economic growth

Question 32

What causes inflation?

Demand-pull inflation

Answer 32

§: Inflation that is caused by an increase in the aggregate demand for goods and services and production levels are unable to meet this demand immediately.

Question 33

Aggregate demand:

Answer 33

–The quantity of goods and services demanded by households, firms and government, plus net exports.

Question 34

demand - pull inflation

why may the production be unable to meet demand

Answer 34

§Production may be unable to meet demand, particularly when the economy is close to, or at, full employment.

Question 35

Demand -pull inflation

what is wage-price sprial

Answer 35

§Upward pressure is put on prices and nominal wages and can lead to a wage-price spiral.

Question 36

causes of inflation

Cost-push inflation

Answer 36

§Inflation that arises as a result of a negative supply shock—that is, anything that causes a decrease in the aggregate supply of goods and services.

–Aggregate supply: The quantity of goods and services supplied by firms.

Question 37

Sources of a supply shock can include

Answer 37

–Increases in import prices
–Increases in wages
–Increases in indirect taxation
–Increases in monopoly power in product markets
–Natural disasters, such as droughts, floods and earthquakes

Question 38

4 biases that cause changes in the CPI to overstate the true inflation rate

Answer 38

1. Substitution bias
2. quality bias
3. new product bias:
4. outlet bias

Question 39

describe substitution bias

Answer 39

The substitution bias is a weakness in the Consumer Price Index that overstates inflation because it does not account for the substitution effect, when consumers choose to substitute one good for another after its price becomes cheaper than the good they normally buy.

they likely substitute away from items that get disproportionately expensive to goods that got comparatively less expensive.

Question 40

describe quality bias

Answer 40

price from increase in quality

overtime technological advancement increases the life and usefulness of products. CPI does not reflect this

product improvements are under-counted)

For example, an average computer today might cost about the same as an an average computer cost last year, but today’s computer is better than last year’s computer in a number of ways that the CPI doesn’t account for.

Question 41

what is new product bias

Question 42

what is new product bias

Answer 42

new products are not introduced in the index until they become commonplace

(new products are not counted for a while after the appear)

Question 43

what is outlet bias

Answer 43

the consumer shift to new outlets such as wholesale clubs and online retailers

Question 44

a severe drought reduces the production of tropical fruit, causing the price of tropical fruit to rise significantly

Answer 44

overestimate, substittion bias, becoming consumers would substitute cheaper foods for tropical fruit

Question 45

new tech signiicantly decreases the price of 3D televisions

Answer 45

accurately reflects a fall in price of consumer goods

Question 46

consumers switch to buying front loadin clothes washing machines instead of the less water efficient top-loading washing machines, even though the front loading washing machines are more expensive

Answer 46

overestimate, similar to new product bias

or quality bias

Question 47

Both the inability of the CPI to incorporate technological progress and its failure to account for substitution in consumption decisions imply that, in most cases,

Answer 47

the Consumer Price Index likely overstates increases in the cost of living that households actually feel.