Content check — Economics, Chapter 22: Inflation

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Chapter 22: Inflation

10 problems · 0 figures

Table 22.4 shows the fruit prices that the typical college student purchased from 2001 to 2004. What is the amount spent each year on the “basket” of fruit with the quantities shown in column 2?

Table 22.4 in the book ↗

Items	Qty	(2001) Price	(2002) Price	(2003) Price	(2004) Price	(2004) Amount Spent
Apples	10	$0.50	$0.75	$0.85	$0.88
Bananas	12	$0.20	$0.25	$0.25	$0.29
Grapes	2	$0.65	$0.70	$0.90	$0.95
Raspberries	1	$2.00	$1.90	$2.05	$2.13	$2.13
Total

Answer

To compute the amount spent on each fruit in each year, you multiply the quantity of each fruit by the price.

• 10 apples × 50 cents each = $5.00 spent on apples in 2001.

• 12 bananas × 20 cents each = $2.40 spent on bananas in 2001.

• 2 bunches of grapes at 65 cents each = $1.30 spent on grapes in 2001.

• 1 pint of raspberries at $2 each = $2.00 spent on raspberries in 2001.

Adding up the amounts gives you the total cost of the fruit basket. The total cost of the fruit basket in 2001 was $5.00 + $2.40 + $1.30 + $2.00 = $10.70. The total costs for all the years are shown in the following table.

2001	2002	2003	2004
$10.70	$13.80	$15.35	$16.31

22-2 §22.1 source ↗

Construct the price index for a “fruit basket” in each year using 2003 as the base year.

Answer

If 2003 is the base year, then the index number has a value of 100 in 2003. To transform the cost of a fruit basket each year, we divide each year’s value by $15.35, the value of the base year, and then multiply the result by 100. The price index is shown in the following table.

2001	2002	2003	2004
69.71	89.90	100.00	106.3

Note that the base year has a value of 100; years before the base year have values less than 100; and years after have values more than 100.

22-3 §22.1 source ↗

Compute the inflation rate for fruit prices from 2001 to 2004.

Answer

The inflation rate is calculated as the percentage change in the price index from year to year. For example, the inflation rate between 2001 and 2002 is (89.90 – 69.71) / 69.71 = 0.2137 = 28.96%. The inflation rates for all the years are shown in the last row of the following table, which includes the two previous answers.

Items	Qty	(2001) Price	(2001) Amount Spent	(2002) Price	(2002) Amount Spent	(2003) Price	(2003) Amount Spent	(2004) Price	(2004) Amount Spent
Apples	10	$0.50	$5.00	$0.75	$7.50	$0.85	$8.50	$0.88	$8.80
Bananas	12	$0.20	$2.40	$0.25	$3.00	$0.25	$3.00	$0.29	$3.48
Grapes	2	$0.65	$1.30	$0.70	$1.40	$0.90	$1.80	$0.95	$1.90
Raspberries	1	$2.00	$2.00	$1.90	$1.90	$2.05	$2.05	$2.13	$2.13
Total			$10.70		$13.80		$15.35		$16.31
Price Index			69.71		89.90		100.00		106.3
Inflation Rate					28.96%		11.23%		6.3%

22-4 §22.1 source ↗

Edna is living in a retirement home where most of her needs are taken care of, but she has some discretionary spending. Based on the basket of goods in Table 22.5, by what percentage does Edna’s cost of living increase between time 1 and time 2?

Table 22.5 in the book ↗

Items	Quantity	(Time 1) Price	(Time 2) Price
Gifts for grandchildren	12	$50	$60
Pizza delivery	24	$15	$16
Blouses	6	$60	$50
Vacation trips	2	$400	$420

Answer

Begin by calculating the total cost of buying the basket in each time period, as shown in the following table.

Items	Quantity	(Time 1) Price	(Time 1) Total Cost	(Time 2) Price	(Time 2) Total Cost
Gifts	12	$50	$600	$60	$720
Pizza	24	$15	$360	$16	$384
Blouses	6	$60	$360	$50	$300
Trips	2	$400	$800	$420	$840
Total Cost			$2,120		$2,244

The rise in cost of living is calculated as the percentage increase:

(2244 – 2120) / 2120 = 0.0585 = 5.85%.

22-5 §22.2 source ↗

How to Measure Changes in the Cost of Living introduced a number of different price indices. Which price index would be best to use to adjust your paycheck for inflation?

Answer

Since the CPI measures the prices of the goods and services purchased by the typical urban consumer, it measures the prices of things that people buy with their paycheck. For that reason, the CPI would be the best price index to use for this purpose.

22-6 §22.2 source ↗

The Consumer Price Index is subject to the substitution bias and the quality/new goods bias. Are the Producer Price Index and the GDP Deflator also subject to these biases? Why or why not?

Answer

The PPI is subject to those biases for essentially the same reasons as the CPI is. The GDP deflator picks up prices of what is actually purchased that year, so there are no biases. That is the advantage of using the GDP deflator over the CPI.

22-7 §22.3 source ↗

Go to this website for the Purchasing Power Calculator at MeasuringWorth.com. How much money would it take today to purchase what one dollar would have bought in the year of your birth?

Answer

The calculator requires you to input three numbers:

• The first year, in this case the year of your birth

• The amount of money you would want to translate in terms of its purchasing power

• The last year—now or the most recent year the calculator will accept

My birth year is 1955. The amount is $1. The year 2012 is currently the latest year the calculator will accept. The simple purchasing power calculator shows that $1 of purchases in 1955 would cost $8.57 in 2012. The website also explains how the true answer is more complicated than that shown by the simple purchasing power calculator.

22-8 §22.4 source ↗

If inflation rises unexpectedly by 5%, would a state government that had recently borrowed money to pay for a new highway benefit or lose?

Answer

The state government would benefit because it would repay the loan in less valuable dollars than it borrowed. Plus, tax revenues for the state government would increase because of the inflation.

22-9 §22.5 source ↗

How should an increase in inflation affect the interest rate on an adjustable-rate mortgage?

Answer

Higher inflation reduces real interest rates on fixed rate mortgages. Because ARMs can be adjusted, higher inflation leads to higher interest rates on ARMs.

22-10 §22.5 source ↗

A fixed-rate mortgage has the same interest rate over the life of the loan, whether the mortgage is for 15 or 30 years. By contrast, an adjustable-rate mortgage changes with market interest rates over the life of the mortgage. If inflation falls unexpectedly by 3%, what would likely happen to a homeowner with an adjustable-rate mortgage?

Answer

Because the mortgage has an adjustable rate, the rate should fall by 3%, the same as inflation, to keep the real interest rate the same.

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Problems and answers are adapted from Principles of Economics 3e by Steven A. Greenlaw, David Shapiro and Daniel MacDonald, OpenStax, and are used under the CC BY-NC-SA 4.0 licence. Access for free at https://openstax.org/books/principles-economics-3e/pages/1-introduction. Illustrations: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license. This adaptation is released under the same licence, is non-commercial, and is neither affiliated with nor endorsed by OpenStax or Rice University.