Chapter 7

Practice Quiz
Inflation
1. Inflation is
a. an increase in the general price level.
b. not a concern during war.
c. a result of high unemployment.
d. an increase in the relative price level.
ANS:
a. Inflation is always a concern and it is not caused by a high unemployment rate.
2. If the consumer price index in Year X was 300 and the CPI in Year Y was 315, the rate
of inflation was
a. 5 percent.
b. 5 percent.
c. 25 percent.
d. 315 percent.
ANS:
a. CPI = [315 300/300] x 100 = 5 percent
3. Consider an economy with only two goods: bread and wine. In the base year, the
typical family bought four loaves of bread at $2 per loaf and two bottles of wine for $9
per bottle. In a given year, bread cost $3 per loaf, and wine cost $10 per bottle. The CPI
for the given year is
a. 100.
b. 123.
c. 126.
d. 130.
ANS:
b. CPI = (market basket cost at given-year prices) divided by (market basket cost at baseyear prices) times 100
132 = [$32/$26] X 100

4. As shown in Exhibit 6, the rate of inflation for Year 2 is

a. 5 percent.
b. 10 percent.
c. 20 percent.
d. 25 percent.
ANS:
b. A percent increase of decrease between two numbers is the difference divided by the
original number. In this case, it is 10 / 100 = 10 percent.
5. As shown in Exhibit 6, the rate of inflation for Year 5 is
a. 4.2 percent.
b. 5 percent.
c. 20 percent.
d. 25 percent.
ANS:
a. A percent increase or decrease between two numbers is the difference divided by the
original number. In this case, it is 5 / 120 = 4.2 percent.
6. Deflation is a (an):
a. increase in most prices.
b. decrease in the general price level.
c. situation that has never occurred in U.S. history.
d. decrease in the inflation rate.
ANS:
b. Inflation is an increase in most prices and deflation did occur in the U.S. during the
Great Depression of the 1930s.

7. Which of the following would overstate the consumer price index?

a. Substitution bias
b. Improving quality of products
c. Neither (a) nor (b)
d. Both (a) and (b)
ANS:
d. Substitution bias refers to the law of demand in which people buy less when the price
rises. However, the CPI is based on a fixed market basket. Since improving quality is
difficult to measure, increases in the CPI overstate inflation.
8. Suppose a typical automobile tire cost $50 in the base year and had a useful life of
40,000 miles. Ten years later, the typical automobile tire cost $75 and had a useful life of
75,000 miles. If no adjustment is made for mileage, the CPI would
a. underestimate inflation between the two years.
b. overestimate inflation between the two years.
c. accurately measure inflation between the two years.
d. not measure inflation in this case.
ANS:
b. Quality changes are difficult to measure. When the quality of items improves,
increases in the CPI overstate the change in prices.
9. When the inflation rate rises, the purchasing power of nominal income
a. remains unchanged.
b. decreases.
c. increases.
d. changes by the inflation rate minus one.
ANS:
b. Real income = nominal income/CPI (expressed as a decimal)
A larger value for the CPI decreases nominal income.
10. Last year the Harrison family earned $50,000. This year their income is $52,000. In
an economy with an inflation rate of 5 percent, which of the following is correct?
a. The Harrisons nominal income and real income have both risen.
b. The Harrisons nominal income and real income have both fallen.
c. The Harrisons nominal income has fallen, and their real income has risen.
d. The Harrisons nominal income has risen, and their real income has fallen.
ANS:
d. percentage change real income 52,000 - 50,000/50,000 = 5 percent,
4 percent - 5 percent = -1 percent

11. If the nominal rate of interest is less than the inflation rate,
a. lenders win.
b. savers win.
c. the real interest rate is negative.
d. the economy is at full employment.
ANS:
c. The real rate of interest is negative because the lender is receiving less money back, in
real terms, than was lent out.
12. Demand-pull inflation is caused by
a. monopoly power.
b. energy cost increases.
c. tax increases.
d. full employment.
ANS:
d. Demand-pull inflation is caused by an excess of total spending (demand) at or close to
full employment. At full employment, sellers cannot respond by raising prices.
13. Cost-push inflation is due to
a. excess total spending.
b. too much money chasing too few goods.
c. resource cost increases.
d. the economy operating at full employment.
ANS:
c. Answers a, b, and d describe demand-pull inflation.
14. Suppose you place $10,000 in a retirement fund that earns a nominal interest rate of 8
percent. If you expect inflation to be 5 percent or lower, then you are expecting to earn a
real interest rate of at least
a. 1.6 percent.
b. 3 percent.
c. 4 percent.
d. 5 percent.
ANS:
b. The real interest rate is the nominal interest rate minus the inflation rate.

15. Which of the following statements is true?

a. Demand-pull inflation is caused by excess total spending.
b. Cost-push inflation is caused by an increase in resource costs.
c. If nominal interest rates remain the same and the inflation rate falls, real interest rates
increase.
d. If real interest rates are negative, lenders incur loses.
e. All of the above are true.
ANS:
e. Each of the above answers is correct.