Chapter 7 Review Questions Price Indexes and Inflation, Study notes of Business

Download Chapter 7 Review Questions Price Indexes and Inflation and more Study notes Business in PDF only on Docsity! Chapter 7 Review Questions Price Indexes and Inflation Dr. McGahagan _True__1. Inflation typically falls in recessions and increases in good times. __False_2. The GDP deflator is a price index which fixes quantities in the base year. Prices are fixed in the base year and quantities vary with the data. _True__3. The CPI typically shows a higher rate of inflation than the GDP deflator. The CPI ignores the substitution effect. _False__4. If the GDP deflator were 150 in 2010 and goes up to 160 in 2011, the inflation rate calculated in 2011 would be 10 percent. There is a 10 point increase in the GDP deflator, but the inflation rate is the percentage change (160 – 150) / 150 = 10 / 150 = .067 or 6.7 % _False__5. One problem with the GDP deflator is that it neglects the substitution effect. The CPI is the price index that neglects the substitution effect _False_6. The substitution effect is the tendency of people to buy relatively more of luxury goods when their income rises. It is the tendency of people to protect themselves against inflation by purchasing more of goods which have become relatively cheaper (that may have risen in price, but less than other goods) and to avoid goods which have become relatively more expensive. _True_7. The core PCE deflator is the measure most closely watched by the Federal Reserve as an indicator of inflation. The core PCE deflator is constructed on the same principles as the GDP deflator but covers only Personal Consumption Expenditures – prices are fixed in the base year, and quantities vary. The “core” part means that it strips out volatile prices such as energy and food. One alternative now getting attention is a “trimmed mean” PCE, which omits both the very high and very low price rises from the calculation of inflation. _False_8. The real interest rate is the nominal interest rate divided by a price index. The real interest rate is already a percentage, and to adjust from inflation one subtracts off the inflation rate. _False_9. Unexpected inflation will benefit banks and other lenders. It benefits borrowers, who will be able to pay back their loans in less valuable dollars. _False__10. Falling prices automatically benefit all sectors of an economy. Lower prices for what one buys is good for the purchaser – but also mean lower revenues for firms, and lower incomes for the factors of production (remember the Circular Flow!) Unexpectedly low inflation will also harm borrowers, who must now pay back their debts in dollars that are worth more than previously. _True_11. Sudden and unexpected deflation is more likely to be harmful to economic growth than sudden and unexpected inflation. Inflation may mean some redistribution of income from lenders to borrowers, and some inefficiency in interpreting price signals, but moderate inflation does not seem to affect overall economic growth. Deflation forces personal and corporate bankruptcies, as borrowers are no longer able to repay debts (farmers are unable to pay off their mortgages with lower crop prices, firms face sticky wages in the short run and falling prices for their products). _False__12. The United States has not seen deflation since the Great Depression. Consider the CPI for 2008 215.3 2009 214.5 Inflation rate = (214.5 - 215.3) / 215.3 = 0.8 / 215.3 = .00372 or 0.372 % Less than ½ percent deflation, but still deflation. _True_13. Prices of goods and services which are labor-intensive tend to be sticky; prices of goods that are raw- materials intensive tend to be flexible. See the interesting “inflation project” of the Atlanta Federal Reserve, as reported by Michael Bryan and Brent Meyer in their article “Are Some Prices More Forward Looking than Others? We Think So” (May, 2010), on the web at http://www.clevelandfed.org/Research/commentary/2010/2010-2.cfm Motor fuel goes only 0.7 months between changes in price, fruit and vegetables 1.3 months, women's apparel 2.3 months, men's apparel 3.2 months – relatively flexible prices, which can clear a market quickly. Sticky price items include motor vehicle repair (5.3 months), education services (11.1 months), medical services (14.0 months). The market may not adjust to equilibrium quickly, and this has consequences for the business cycle. _True_14. The CPI was 215 in 2008 and 214 in 2009. The rate of inflation was about half a percent between 2008 and 2009. (See the more exact calculation in question 12). Given the following data, answer the following questions. Show all your work, clearly indicating the operations you are conducting. Assume that 2011 is the base year. Also assume that these are the only two goods produced, and that both are produced domestically, so that the coverage of the CPI and the GDP deflator is the same. PRICES QUANTITIES Good X Good Y Good X Good Y 2011 $ 50 $ 100 30 20 2012 $ 40 $ 110 20 30 ___$ 3500__15. Nominal GDP in 2011 is --- Nominal GDP 2011 = $ 50 * 30 + $ 100 * 20 = $ 1500 + $ 2000 = $ 3500 ___$ 3500___16. Real GDP in 2011 is --- (in the base year, real and nominal GDP are the same) ___$ 4100___17. Nominal GDP in 2012 is ---- $ 40 * 20 + $ 110 * 30 = $ 800 + $ 3300 = $ 4100 __$ 4000___18. Real GDP in 2012 is --- Use 2011 prices and 2010 quantities: $ 50 * 20 + $ 100 * 30 = $ 1000 + $ 3000 = $ 4000 __14.29 %_20. The real GDP growth rate between 2011 and 2012 is ---- (4000 – 3500) / 3500 = .1429 or 14.29 percent.