Tutorial 3

Measuring the Cost of Living

I. Terms

1. consumer price index (CPI)

2. inflation rate
3. nominal interest rate
4. real interest rate

II. Short-Answer Questions

1. Explain briefly what the consumer price index measures and how it is
constructed.
2. Which do you think has a greater effect on the consumer price index: a 10
percent increase in the price of chicken or a 10 percent increase in the price of
caviar? Why?
3. Suppose there is an increase in the price of imported BMW automobiles
( which are produced in Germany). Would this have a larger impact on the
CPI or the GDP deflator? Why?
4. If the price of a Navy submarine rises, is the consumer price index or the
GDP deflator affected more? Why?
5. Explain the meaning of nominal interest rate and real interest rate. How are
they related?
6. Suppose you lend money to your sister at a nominal interest rate of 10 %
because you both expect the inflation rate to be 6 %. Furthermore, suppose
that after the loan has been repaid, you discover that the actual inflation rate
over the life of the loan was only 2%. Who gained at the other’s expense- you
or your sister? Why?

III. Practice problems

1. Henry Ford paid his workers $5 a day in 1914. If the consumer price index
was 10 in 1914 and 218 in 2010, how much is the Ford paycheck worth in
2010 dollars?
2. The residents of Vegopia spend all of their income on cauliflower, broccoli,
and carrots. In 2010, they buy 100 heads of cauliflower for $200, 50 bunches
of broccoli for $75, and 500 carrots for $50. In 2011, they buy 75 heads of
cauliflower for $225, 80 bunches of broccoli for $120, and 500 carrots for
$100.
a. Calculate the price of each vegetable in each year.
b. Using 2010 as the base year, calculate the CPI for each year.
c. What is the inflation rate in 2011?
3. A small nation of ten people idolizes the TV show American Idol. All they
produce and consume are karaoke machines and CDs, in the following
amounts:
Karaoke Machines CDs
Quantity Price Quantity Price
2011 10 $40 30 $10
2012 12 60 50 12
 a. Using a method similar to the consumer price index, compute the
percentage change in the overall price level. Use 2011 as the base year,
and fix the basket at 1 karaoke machine and 3 CDs.
b. Using a method similar to the GDP deflator, compute the percentage
change of the overall price level. Also use 2011 as the base year.
c. Is the inflation rate in 2012 the same using the two methods?
Explain why or why not.
4. Which of the problems in the construction of the CPI might be illustrated by
each of the following situations? Explain.
a. the invention of the iPod
b. the introduction of air bags in cars
c. increased personal computer purchases in response to a decline in their
price
5. The New York Times cost $0.15 in 1970 and $2.00 in 2009. The average wage
in manufacturing was $3.23 per hour in 1970 and $20.42 in 2009.
a. By what percentage did the price of a newspaper rise?
b. By what percentage did the wage rise?
c. In each year, how many minutes does a worker have to work to earn
enough to buy a newspaper
d. Did workers’ purchasing power in terms of newspapers rise or fall?
6. Suppose that a borrower and a lender agree on the nominal interest rate to be
paid on a loan. Then inflation turns out to be higher than they both expected.
a. Is the real interest rate on this loan higher or lower than expected?
b. Does the lender gain or lose from this unexpectedly high inflation? Does
the borrower gain or lose?
c. Inflation during the 1970s was much higher than most people had
expected when the decade began. How did this affect homeowners who
obtained fixed-rate mortgages during the 1960s? How did it affect the
banks that lent the money?

IV. Multiple- Choice Questions

1. Inflation can be measured by all of the following except the

a. GDP deflator.
b. Consumer price index.
c. Producer price index.
d. Finished goods price index.
e. All of the above are used to measure inflation.

2. The CPI will be most influenced by a 10 percent increase in the price of which of
the following consumption categories?
a. housing
b. transportation
c. medical care
d. food and beverages
e. All of the above would produce the same impact.

3. In 1989, the CPI was 124.0. In 1990 it was 130.7. What was the rate of inflation
over this period?
a. 5.1 percent
 b. 5.4 percent
c. 6.7 percent
d. 30.7 percent
e. You can’t tell without knowing the base year.

4. Which of the following would likely cause the CPI to rise more than the GDP
deflator?
a. an increase in the price of Fords
b. an increase in the price of tanks purchased by the military
c. an increase in the price of domestically produced fighter planes sold
exclusively to Israel
d. an increase in the price of Hondas produced in Japan and sold in the United
States
e. an increase in the price of Jhon Deere tractors

5. The “basket” on which the CPI is based is composed of

a. Raw materials purchased by firms.
b. Total current production.
c. Products purchased by the typical consumer.
d. Consumer production.
e. None of the above.

6. If there is an increase in the price of apples that causes consumers to purchase

fewer pounds of apples and more pounds of oranges, the CPI will suffer from
a. substitution basis
b. Bias due to the introduction of new goods.
c. Bias due to unmeasured quality change.
d. Base-year bias.
e. None of the above.

7. Suppose your income rises from $19,000 to $31,000 while the CPI rises from 122
to 169. Your standard of living has likely
a. Fallen.
b. Risen.
c. Stayed the same.
d. You can’t tell without knowing the base year.

8. If the nominal interest rate is 7 percent and the inflation rate is 3 percent, then the
real interest rate is
a. -4 percent.
b. 3 percent
c. 4 percent.
d. 10 percent.
e. 21 percent.

9. Which of the following statements is correct?

a. The real interest rate is the sum of the nominal interest rate and the inflation
rate.
b. The real interest rate is the nominal interest rate minus the inflation rate.
c. The nominal interest rate is the inflation rate minus the real interest rate.
 d. The nominal interest rate is the real interest rate minus the inflation rate.
e. None of the above is true.

10. If inflation is 8 percent and the real interest rate is 3 percent, then the nominal
interest rate should be
a. 3/8 percent.
b. 5 percent.
c. 11 percent.
d. 24 percent.
e. -5 percent.

11. Under which of the following conditions would you prefer to be the lender?
a. The nominal rate of interest is 20 percent and the inflation rate is 25 percent.
b. The nominal rate of interest is 15 percent and the inflation rate is 14 percent.
c. The nominal rate of interest is 12 percent and the inflation rate is 9 percent.
d. The nominal rate of interest is 5 percent and the inflation rate is 1 percent.

12. Under which of the following conditions would you prefer to be the borrower?
a. The nominal rate of interest is 20 percent and the inflation rate is 25 percent.
b. The nominal rate of interest is 15 percent and the inflation rate is 14 percent.
c. The nominal rate of interest is 12 percent and the inflation rate is 9 percent.
d. The nominal rate of interest is 5 percent and the inflation rate is 1 percent.

13. If borrowers and lenders agree on a nominal interest rate and inflation turns out to
be less than they had expected,
a. Borrowers will gain at the expense of lenders.
b. Lenders will gain at the expense of borrowers.
c. Neither borrowers nor lenders will gain because the nominal interest rate has
been fixed by contract.
d. None of the above is true.

14. If workers and firms agree on an increase in wages based on their expectations of
inflation and inflation turns out to be more than they expected,
a. Firms will gain at the expense of workers.
b. Workers will gain at the expense of firms.
c. Neither workers nor firms will gain because the increase in wages is fixed in
the labor agreement.
d. None of the above is true.