Chapter 11 Measuring the Cost of Living True False

Chapter 11/Measuring the Cost of Living  325 TRUE/FALSE 1. The CPI for 2000 is computed as 100 times the ratio of the price of the market basket in 2000 divided by the price of the market basket in the base year. ANSWER: T TYPE: TF DIFFICULTY: 1 SECTION: 11.1 2. The CPI is computed by finding the price of a market basket of goods whose contents vary each year. ANSWER: F TYPE: TF DIFFICULTY: 1 SECTION: 11.1 3. If the current year CPI is 140 then since the base year, the price level has increased 40 percent. ANSWER: T TYPE: TF DIFFICULTY: 1 SECTION: 11.1 4. The inflation rate is computed as the 100 times the (the current year CPI minus the CPI of the previous year) divided by the CPI of the previous year. ANSWER: T TYPE: TF DIFFICULTY: 1 SECTION: 11.1 5. Food and Beverages, plus medical care, and apparel account for over 50 percent of the goods and services in the CPI basket of goods. ANSWER: F TYPE: TF DIFFICULTY: 1 SECTION: 11.1 6. Substitution bias in computing the CPI tends to make the CPI overstate the true increase in the cost of living. ANSWER: T TYPE: TF DIFFICULTY: 1 SECTION: 11.1 7. There is no longer much debate among economists concerning the severity of and the solution to the problems in using the CPI to measure the cost of living. ANSWER: F TYPE: TF DIFFICULTY: 1 SECTION: 11.1 8. Since it accounts for changes in the prices of imports and the GDP deflator does not, the CPI is based on more goods and services than the GDP deflator. ANSWER: F TYPE: TF DIFFICULTY: 1 SECTION: 11.1 9. Although they sometimes diverge, generally the CPI and GDP deflator move in the same direction. ANSWER: T TYPE: TF DIFFICULTY: 1 SECTION: 11.1 326  Chapter 11/Measuring the Cost of Living 10. Suppose that the CPI today is 120 and that it was 80 five years ago. Then in today’s prices something that cost $1 five years ago now costs $1.50. ANSWER: T TYPE: TF DIFFICULTY: 1 SECTION: 11.2 11. Henry Ford paid his workers $5 a day in 1914 when the CPI was 10. Today with the price index at 177 the $5 a day is worth $88.50. ANSWER: T TYPE: TF DIFFICULTY: 2 SECTION: 11.2 12. If you currently make $25,000 a year and the CPI rises from 110 today to 150 in five years, then you need to be making $35,000 to have kept pace with consumer price inflation. ANSWER: F TYPE: TF DIFFICULTY: 1 SECTION: 11.2 13. The U.S. income tax system is completely indexed to the CPI. ANSWER: F TYPE: TF DIFFICULTY: 1 SECTION: 11.2 14. If the nominal interest rate is 5 percent and the inflation rate is 2 percent, then the real interest rate is 3 percent. ANSWER: T TYPE: TF DIFFICULTY: 1 SECTION: 11.2 15. In the 1970s nominal interest rates were high and real interest rates were low. In the 1990s nominal interest rates were low and real interest rates were high. ANSWER: T TYPE: TF DIFFICULTY: 1 SECTION: 11.2 16. If nominal interest rates rise, it must be because inflation rose. ANSWER: F TYPE: TF DIFFICULTY: 1 SECTION: 11.2 SHORT ANSWER 1. In a simple economy, people consume only 2 goods, food and clothing. The market basket of goods used to compute the CPI has 50 units of food and 10 units of clothing. 2002 price 2003 price food $4 $6 clothing $10 $20 a. What are the percentage increases in the price of food and in the price of clothing? b. What is the percentage increase in the CPI? c. Do these price changes affect all consumers to the same extent? Explain. ANSWER: a. The price of food increased by 50 percent. The price of clothing increased by 100 percent. b. In 2002 the market basket cost $300 in 2003 it cost $500. The percentage increase in the CPI is 200/300 = 66.7 percent c. Since the price of clothing increased relatively more than did the price of food, people who purchase a lot of clothing and little food became worse off relative to people who purchase a lot of food and little clothing. TYPE: S DIFFICULTY: 2 SECTION: 11.1 Chapter 11/Measuring the Cost of Living  327 2. Which is likely to have the larger effect on the CPI, a 2 percent increase in food or a 3 percent increase in diamond rings? Explain. ANSWER: The 2 percent increase in food will increase the CPI by more because the portion of the market basket that is for food is much larger than the portion for diamond rings. TYPE: S DIFFICULTY: 2 SECTION: 11.1 3. List the three major problems in using the CPI as a measure of the cost of living. ANSWER: (1) Substitution bias. The CPI ignores the fact that consumers substitute toward goods that have become relatively less expensive. (2) introduction of new goods. Because the CPI uses a fixed basket of goods, it does not take into account the increased well-being of consumers created when new goods are introduced. (3) Unmeasured quality change. Not all quality changes can be measured. TYPE: S DIFFICULTY: 2 SECTION: 11.1 4. Why does the GDP deflator give a different rate of inflation than does the CPI? ANSWER: The GDP deflator and the CPI differ in two important ways. The GDP deflator uses as a basket of goods all final goods and services produced in the domestic economy, while the CPI basket includes goods and services purchased by typical consumers. Therefore, changes in the price of imported goods affect the CPI, but not the GDP deflator. Also, changes in the price of domestically produced capital goods affect the GDP deflator, but not the CPI. Changes in the price of domestically produced consumer goods are likely to affect the CPI more than the GDP deflator because it is likely that those goods make up a larger part of consumer budgets than of GDP. TYPE: S DIFFICULTY: 3 SECTION: 11.1 5. Compute how much each of the following is worth in terms of today’s dollars using 177 as the price index for today. a. In 1926 the CPI was 17.7 and the price of a movie ticket was $0.25 b. In 1932 the CPI was 13.1 and a cook earned $15.00 a week c. In 1943 the CPI was 17.4 and a gallon of gas cost $0.19 ANSWER: a. The movie ticket is worth $.25 x 177/17.7 = $2.50 in today’s dollars b. the cooks weekly wage is worth $15.00 x 177/13.1 = $202.67 in today’s dollars c. the gallon of gas is worth $.19 x 177/17.4 = $1.93 in today’s dollars TYPE: S DIFFICULTY: 2 SECTION: 11.2 6. Jay and Joyce meet George, the banker, to work out the details of a mortgage. They all expect that inflation will be 2 percent over the term of the loan, and they agree on a nominal interest rate of 6 percent. As it turns out, the inflation rate is 5 percent over the term of the loan. a. What was the expected real interest rate? b. What was the actual real interest rate? c. Who benefited and who lost because of the unexpected inflation? ANSWER: a. The expected real interest rate was 4 percent. b. The actual real interest rate was 1 percent. c. George, the banker, lost because he receives less real interest income than he expected. Jay and Joyce gain because they pay less real interest income than they expected. TYPE: S