Chapter -6 (Macroeconomics by Roger A Arnold)

Answers to Text Questions and Problems for Chapter 6

Answers to Review Questions

1. The CPI measures the cost of buying a particular basket of goods and services, relative to a
specified base year. The official basket of goods and services is intended to correspond to the buying
patterns of the typical family. However, a family whose buying patterns differ from the average may find
that changes in its cost of living are not well captured by the official CPI. For example, if the price of
peanut butter rises sharply, the cost of living of a family that buys much more peanut butter than the
typical family will increase more than the CPI, all else being equal.

2. The price level measures the cost of a basket of goods and services, relative to a base year. The CPI
is one standard measure of the price level. In contrast, the rate of inflation is the annual percentage change
in the price level. For example, suppose that the basket of goods and services on which the CPI is based
cost $100 in the base year, $150 last year, and $154.50 this year. The price level this year is 1.5450
($154.50/$100.00). The inflation rate from last year to this is the percentage increase in the cost of the
basket since last year, or 3%.

3. With inflation, increases in nominal quantities may simply reflect higher prices, rather than
increased production or purchasing power. For example, a 10% increase in a workers nominal wage
implies a 10% increase in purchasing power if prices are unchanged, but no increase in purchasing power
if prices have also risen by 10%. The basic method of adjusting for inflation, called deflating the nominal
quantity, is to divide by a price index, such as the CPI. For example, the real wage, equal to the nominal
wage divided by a price index, measures the purchasing power of the wage. Unlike nominal wages, real
wages at different points in time can be meaningfully compared.

4. In an indexed collective agreement, wages each year would automatically be increased at the rate of
inflation, preserving the purchasing power of the agreed-upon wage. For example, if prices of consumer
goods rise by 2% over the year (that is, the rate of inflation is 2%), an indexed wage will also
automatically rise by 2%, so that the quantity of goods the worker can purchase is unchanged.

5. The first two sentences are correct; the losses that unanticipated inflation imposes on creditors (for
example) are just offset by the gains to debtors. However, there is an overall cost to society when wealth
is redistributed arbitrarily. First, risk is increased, which makes people feel worse off. Second, when
wealth is determined more by random forces than by hard work and intelligent investment, the incentives
to engage in the latter are reduced, harming the efficiency of the economy. Finally, people use up
resources attempting to anticipate inflation and protect themselves against it; from societys point of view,
these resources are wasted.

6. The real return on any asset is the nominal return (or nominal interest rate) minus the inflation rate.
The nominal return on cash is zero, so the real return equals minus the inflation rate. If there is inflation,
then the real return on holding cash is reduced (thus acting as a tax on criminals holding large quantities
of cash), but if there is deflation, then the real return on holding cash is increased.

7. True, ignoring complications introduced by taxes. Suppose borrower and lender agree on a 2% real
return on the loan. If they correctly anticipate that inflation over the life of the loan will be, say, 5%, than
setting a 7% nominal interest rate on the loan ensures that the lender receives and the borrower pays a 2%
real return, as agreed beforehand.
8. Deflation is associated with weak or negative economic growth, partly due to deliberate central bank
policy and partly due to a reluctance to invest when cash obtains a sufficiently high return. High and
accelerating inflation is not associated with low economic growth but is still disliked, both because it
makes the future inflation rate difficult to predict and because it may lead either to hyperinflation or to
contractionary policies aimed to lower inflation. Hyperinflation is associated with poor economic
performance, due to the increased costs of making economic transactions.

Answers to Problems

1a. The cost of the basket in the base year is $200 + $600 + $100 + $50, or $950. In the subsequent year,
the same basket of goods costs $220 + $640 + $120 + $40, or $1020. The CPI in the subsequent year
equals the cost of the basket in that year relative to the base year: $1020/$950 = 1.074. Since the CPI in
the base year is 1.000, the rate of inflation (equal to the percentage increase in the CPI) between the base
year and the subsequent year is 7.4%.
b. The familys nominal income rose by 5%, less than the increase in the cost of living. So the family is
worse off, in terms of real purchasing power.

2. 1999 (92.9 91.3)/91.3 = 0.0175 = 1.75%

2000 (95.4 92.9)/92.9 = 0.0269 = 2.69%
2001 (97.8 95.4)/95.4 = 0.0252 = 2.52%
2002 (100.0 97.8)/97.8 = 0.0225 = 2.25%
2003 (102.8 100.0)/100.0 = 0.0280 = 2.80%
2004 (104.7 102.8)/102.8 = 0.0185 = 1.85%
2005 (107.0 104.7)/104.7 = 0.0220 = 2.20%
2006 (109.1 107.0)/107.0 = 0.0196 = 1.96%
2007 (111.5 109.1)/109.1 = 0.0220 = 2.20%

Inflation rates throughout the 1999-2007 period would be considered low.

3. The table below shows that a 10 percent rise in food prices will have a bigger effect in China and
India than in Canada or the United States.

Country Share of Food in Predicted

CPI (%) Increase in CPI
(%)
Canada 17 1.7
China 33 3.3
India 46 4.6
United States 14 1.4

4. The question tells us that the real entry-level wage in 2007 is 8 percent lower than the real entry-
level wage in 2000. Using the CPI data from problem 2, the real entry-level wage in 2007 was
$12.00/0.954 = $12.58 (using 2002 as the base year). The real entry-level wage in 2000 was thus $12.58
divided by 0.92, or $13.67. Again using the CPI data, the nominal entry-level wage in 2000 must have
been $13.67 multiplied by the CPI of 0.954, or $13.04.
5. The rate of inflation between 2008 and 2009 (the percentage increase in the price level) is (185
175)/175 = 5.7%. To keep tax brackets at the same points in terms of real income, the nominal income
categories should each be increased by 5.7%. The year-2009 tax schedule should be adjusted to read:

Family income Tax rate

<$21,140 10%
$21,141$31,710 12%
$31,711$52,850 15%
$52,851$84,560 20%
>$84,561 25%

6. A consumer who spent $100 in the base year would spend $16.30 on food, $28.50 on shelter, $10.70
on household operations and furnishings, and so on. To buy the goods and services this year that cost
$100 in the base year, the consumer would have to increase his spending on food from $16.30 to $17.12
(a 5% rise), on shelter from $28.50 to $31.35 (a 10% rise), and on recreation, education, and reading from
$12.10 to $14.52 (a 20% rise). Other expenditures would be the same as in the base year. The total cost of
the basket can be found to be $105.99, so the CPI for the current year is 105.99.

Sample Homework Assignment

1. Below are the values of the CPI (multiplied by 100) for the country Gamma for the years 2003 to
2008. For each year, beginning with 2004, calculate the rate of inflation from the previous year.
Describe what happened to inflation rates between 2003 and 2008.

2003 120
2004 130
2005 138
2006 144
2007 147
2008 150

2. You have just graduated from university. You, your older sister, your mother, and your father are
comparing the starting salaries in your first jobs. The year you each started your first job, the CPI in
that year (multiplied by 100) and your staring salary are given below. Which of you started your first
job with the highest real income?

Year CPI Starting salary

You 2008 110 $32,000
Your father 1973 83 $24,900
Your mother 1983 91 $29,120
Your older sister 1998 100 $26,000

3. You are lending $100 to your roommate for a year. You both agree that you should earn a 5% rate of
return for the year.
a. If you make the loan in the base year, and you expect the inflation rate to be 10% over the year, what
nominal rate of interest should you charge your roommate?
b. If you charge the interest rate you determined in part a, but the actual inflation rate was 12%, what
was your real rate of return on the loan?
Multiple Choice Quiz
1. The consumer price index measures which of the following?
a. The rate of inflation.
b. The rate of deflation.
c. Real prices.
d. The Fisher effect.
e. The average price level.

2. A nominal quantity is
a. adjusted for inflation.
b. measured in terms of its current dollar value.
c. measured in physical terms.
d. deflated.
e. measured in terms of purchasing power.

3. The wage paid to workers measured in terms of purchasing power is the

a. real wage.
b. nominal wage.
c. current wage.
d. dollar wage.
e. market wage.

4. The practice of increasing a nominal quantity according to changes in the price level to prevent
inflation from eroding purchasing power is called
a. nominalizing.
b. deflating.
c. inflating.
d. indexing.
e. contracting.

5. Which of the following is not a cost of inflation?

a. Shoe-leather costs.
b. Distortions of the tax system.
c. The unexpected redistribution of wealth.
d. Interference with long-run planning.
e. Psychological costs.

6. The idea that inflation makes market signals difficult to interpret is called
a. the signal interpretation hypothesis.
b. the price signal distortion hypothesis.
c. the downward nominal wage rigidity hypothesis.
d. the zero bound on nominal interest rates hypothesis.
e. the market bias hypothesis.
7. A situation in which the inflation rate is extremely high is known as
a. megainflation.
b. hyperinflation.
c. hypoinflation.
d. metainflation.
e. superinflation.

8. The annual percentage increase in the purchasing power of a financial asset is called the
a. real interest rate.
b. nominal interest rate.
c. nominal rate of return.
d. purchasing power parity.
e. asset accumulation ratio.

9. When inflation increases, holding all else constant, which of the following will decrease?
a. The real interest rate.
b. The nominal interest rate.
c. The nominal rate of return.
d. The nominal wage rate.
e. The price level.

10. The tendency for nominal interest rates to be high when inflation is high is known as the
a. inflation effect.
b. Fisher effect.
c. Keynesian effect.
d. Bernanke effect.
e. substitution bias effect.

Problems/Short Answer
1. Fill in the blanks in the following table:

Nominal income Real income CPI ( 100)

2006 275 250 a.
2007 b. 300 130
2008 500 c. 125

2. The table below gives the CPI and the price of gasoline per litre in the country Gamma between
2003 and 2008. For each year find the CPI inflation rate and the change in the relative price of
gasoline, both from the previous year. Were the changes in the price of gasoline over this period
more likely due to inflation or to changes in the gasoline market?

Price of gasoline CPI

per litre
2003 0.92 0.96
2004 1.00 0.98
2005 1.25 1.00
2006 1.60 1.03
2007 1.80 1.04
2008 1.95 1.06
Answer Key to Extra Questions in Instructors Manual
Sample Homework Assignment

1. 2004 (130 120)/120 = 8.3%

2005 (138 130)/130 = 6.2%
2006 (144 138)/138 = 4.3%
2007 (147 144)/144 = 2.1%
2008 (150 147)/147 = 2.0%
Inflation rates fell over the period.

2. Your mother (real incomes are listed below).

You: $29,091.
Your father: $30,000.
Your mother: $32,000.
Your sister: $26,000.

3a. 10% + 5% = 15%.

b. 15% 12% = 3%.

Multiple Choice

1. e
2. b
3. a
4. d
5. e
6. b
7. b
8. a
9. a
10. b

Problems/Short Answer

1a. (275/250) 100 = 110.

b. 300 (130/100) = 390.
c. 500/(125/100) = 400.
2. The relative price of gasoline is increasing indicating the increases in the nominal price of gasoline
are due primarily to changes in the market for gasoline rather than an overall increase in the general price
level.

Inflation rate % increase in Relative price of

the price of gasoline
gasoline
2004 2.1% 8.7% 6.6% increase
2005 2.0% 25% 23% increase
2006 3.0% 28% 25% increase
2007 1.0% 12.5% 11.5% increase
2008 1.9% 8.3% 6.4% increase