Measuring the Price Level and Inflation

January 23, 2025

Guanliang Hu

C ITY U NIVERSITY OF H ONG KONG

 Learning Objectives

Measure the cost of living (the consumer price index, CPI)

Apply CPI to adjust dollar amounts for inflation
Analyze the limitations of the CPI as a measure of living cost
Discuss the economic costs of inflation

Price Level and Inflation Adjusting for Inflation Issues with CPI-inflation Costs of Inflation

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 Price Level

Economists and policymakers are interested in the price level: a mea-

sure of the average prices of goods and services in the economy.
Why? For example:
If the price level goes up and the wage does not change, the quan-
tity of goods and services workers can buy will decline
Stable prices are desirable because they allow households and
firms to plan for the future appropriately
• For example, how much money should you save for buying a house?
Each good (or service) has a price. We try to consider an “overall”
price of a group of goods and services. We will study two versions of
price level
GDP Deflator
Consumer Price Index (CPI) [we will focus on ...]

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 Price Level – GDP Deflator

One measure of the price level is GDP deflator, calculated by dividing

nominal GDP by real GDP:

Nominal GDP
GDP deflator =
Real GDP
Nominal GDP
Note: sometimes, GDP deflator = Real GDP × 100

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 Review: Calculating Real GDP – An Example
2012 2021
Product Quantity Price Quantity Price
Haircuts 80 $40 100 $50
Pizzas 90 $11 80 $10
Shoes 15 $90 20 $100

If we set 2012 as the base year:

Nominal GDP in 2012 gives:
80 × $40 + 90 × $11 + 15 × $90 = $5, 540.
Real GDP in 2012 in 2012 dollars is also $5, 540.
Nominal GDP in 2021 is:
100 × $50 + 80 × $10 + 20 × $100 = $7, 000.
Real 2021 GDP in 2012 dollars is:
100 × $40 + 80 × $11 + 20 × $90 = $6, 680.
The gap between normal and real GDP is

• in 2012, 5,540/5,540 = 1.00 • in 2020, 7,000/6,680 = 1.05

If there is no change in prices from 2012 to 2021, then in 2021,

real GDP = normal GDP = 6, 680 and 6, 680/6, 680 = 1.00
So we can interpret the increase from 1.00 to 1.05 as the change in price level .

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 Calculating GDP Deflator – An Example

2017 2018
Nominal GDP $ 19,485 billion $ 20,494 billion
Real GDP $ 18,051 billion $ 18,566 billion
Formula Applied to 2017 Applied to 2018
1.079 1.104

The GDP deflator increased from 1.079 to 1.104:

 
1.104 − 1.079
× 100% = 2.3%
1.079

So we can say the price level rose by 2.3% over this period.

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 Composition of goods (and services) in calculating GDP
deflator
In previous example:

BASE YEAR 2012 2021

Product Prices Quantity Price Quantity Price
Haircuts P1 80 $40 100 $50
Pizzas P2 90 $11 80 $10
Shoes P3 15 $90 20 $100

Growth rate in GDP deflator:

100×$50+80×$10+20×$100 − 80×$40+90×$11+15×$90
100×P1 +80×P2 +20×P3 80×P1 +90×P2 +15×P3
× 100%
80×$40+90×$11+15×$90
80×P1 +90×P2 +15×P3

There are two key differences between year 2012 and 2021:
Price of goods and services in 2012 and 2021 are not identical
Quantities of goods and services in 2012 and 2021 are not iden-
tical, and this is not desirable!
[We are comparing the prices of two distinct groups of goods and
services.]
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 Price Level – Consumer Price Index (CPI)

In the followings, we will learn another commonly-used measure of

price level:
Consumer price index (CPI) measures the cost of a standard
basket of goods and services in a given year relative to the cost
of the same basket of goods and services in the base year
 In economics, the term basket of goods refers to a fixed set of con-
sumer goods or services
 CPI is a measure of the cost of living during a particular period
To calculate CPI in a given year, we need
A basket of goods and services in the base year
Cost to purchase the basket of goods and services in a base year
Cost to purchase the basket of goods and services in the current
year

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 The CPI Market Basket, U.S., December 2018
The consumer price index in the U.S. is a measure of the average of
the prices a typical urban family of four pays for the goods and services
they purchase.

The chart shows the composition of the basket of goods used to cre-
ate the CPI. This basket of goods derives from a survey of 14,000
households by the BLS.

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 Calculating the CPI

To calculate the CPI in a given year, we need:

A basket of goods and services in the base year
Cost to purchase the basket of goods and services in a base year
Cost to purchase the basket of goods and services in the current
year
The CPI in the current year is the cost to purchase the basket of goods
this year, divided by the cost in the base year.

Cost to purchase the basket in the current year

CPI =
Cost to purchase the basket in the base year
The CPI in the base year is 1.
Note: sometimes, by convention, we multiply this by 100, so that the CPI in the base year is 100.
Cost to purchase the basket in the current year
CPI = Cost to purchase the basket in the base year × 100

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 Example: A Simple CPI Calculation

2010 (Base Year) 2020 2021

Product Quantity Price Expenditures Price Expenditures Price Expenditures
Haircuts 1 $50 $50 $100 $100 $85 $85
Pizzas 20 $10 $200 $15 $300 $14.00 $280
Books 20 $ 25 $500 $25 $500 $27.50 $550
TOTAL $750 $900 $915

The table above gives the information we need to create the CPI in
2020 and 2021, using the basket of goods from 2010.

Formula Applied to 2020 Applied to 2021

Expenditures in the current year $900 $915
CPI = Expenditures in the base year $750 = 1.20 $750 = 1.22

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 CPI-inflation

Inflation Rate
The rate of inflation is the annual percentage change in the price level.

Formula Applied to 2020 Applied to 2021

Expenditures in the current year $900 $915
CPI = Expenditures in the base year $750
= 1.20 $750
= 1.22

Based on these data, the inflation rate from 2020 to 2021 is the per-
centage change in the CPI:

1.22 − 1.20
× 100% = 1.7%
1.20
Since the CPI measures consumer prices, it is often referred to as
the cost of living index. CPI-inflation is sometimes used to generate
“fair” increases in wages for workers and government benefits.
Note: when inflation rates are negative there is deflation.

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 Other Price Indexes

CPI measures the cost of a standard basket of goods and services.

So we can change the composition of the basket:
 Core CPI is CPI without energy and food
 Producer price index (PPI)
• The producer price index (PPI) is an average of the prices received
by producers of goods and services at all stages of the production
process.
 Import/Export price index

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 Quiz

A consumer expenditure survey reports the following information on

consumer protein spending:

2019 2020
Price Quantity Price Quantity
Fish $5 5 $7 7
Chicken $3 10 $4 12
Beef $6 7 $5 10

Using 2019 as the base year, by how much does a “cost of protein”
index increase between 2019 and 2020?
A) 5.2 percent
B) 8.6 percent
C) 13.4 percent
D) 14.3 percent

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 Quiz
A consumer expenditure survey reports the following information on
consumer protein spending:

2019 2020
Price Quantity Price Quantity
Fish $5 5 $7 7
Chicken $3 10 $4 12
Beef $6 7 $5 10

Using 2019 as the base year, by how much does a “cost of protein”
index increase between 2019 and 2020?
A) 5.2 percent
B) 8.6 percent
C) 13.4 percent
D) 14.3 percent
Answer: (C); First, note that in the computation of the CPI, the basket of goods and services is fixed
so the quantities remain the same as in the base year. The protein cost in 2019 was (5 × $5) + (10
× $3) + (7 × $6) = $97. Protein cost in 2020 was (5 × $7) + (10 × $4) + (7 × $5) = $110, so the
protein price index is 1.134, or an increase of 13.4 percent.

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 Adjusting for Inflation

A nominal quantity is measured in terms of its current dollar value

A real quantity is measured in physical terms
 Quantities of goods and services [Quantities of the standard bas-
ket?]
To compare values over time, use real quantities
 Deflating a nominal quantity converts it to a real quantity

Nominal variable
Real variable =
Price index
If we use CPI price index, a naı̈ve interpretation of

Nominal variable
Real variable =
CPI
is the “number of the base-year baskets of goods and services”
or, more precisely, the “purchasing power of the nominal quantity.”

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 Family Income in 2015 and 2020 – An example

Can a family buy more with an income of $40,000 in 2015 or with an

income of $44,000 in 2020?
2015 is the base year for the CPI
Deflate nominal income in both years to get real income
Compare real income
The income of $40,000 in 2015 has the greater purchasing power

Year Nominal Income CPI Real Income

2015 $40,000 1.00 $40,000/1.00 = $40,000
2020 $44,000 1.25 $44,000/1.25 = $35,200

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 Real Wage

The real wage is the wage paid to the worker measured in terms of
purchasing power
The real wage for any given period is calculated by dividing the
nominal wage by the CPI for that period
U.S. production worker wages
CPI uses 1982 – 1984 as base year
Real wages stayed roughly the same between 1970 and 2019
despite the fact that the nominal wage in 2019 was almost 7 times
the nominal wage in 1970

Year Nominal Average Wage CPI Real Average Wage

1970 $3.40 0.388 $3.40 / 0.388 = $8.76
2019 $23.51 2.560 $23.51 / 2.56 = $9.18

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 Nominal Interest Rates versus Real Interest Rates

When you lend money to someone, they typically agree to pay you
back with interest.
If the interest rate is 4%, for example, then a $1,000 loan in year
t paid back in year t + 1 will be paid back with $1,040. 4% is
the nominal interest rate: the annual percentage increase in the
dollar value of an asset
We can adjust for inflation by calculating the real interest rate:
the annual percentage increase in the purchasing power of finan-
cial assets.

Real
| {z Rate} ≈ Nominal
Interest | interest
{z rate} − Inflation
| {z rate}
r i π

If prices rise by 2% from this year to next, then your real interest rate on
the loan is only 2%. This more accurately reflects the cost of borrowing
and lending money.

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 (Optional) Proof: r ≈ i − π
Note: if x is close enough to 0, then ln(1 + x) ≈ x

1+i
1+r =
1+π
Taking ln() on both side, we get
 
1+i
ln(1 + r ) = ln
1+π

If r , i, and π are close to 0. we get

ln(1 + r ) ≈ r
and  
1+i
ln = ln (1 + i) − ln (1 + π) ≈ i − π
1+π | {z } | {z }
≈i ≈π

Therefore, r ≈ i − π
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 Nominal and Real Interest Rates, 1970-2017

The chart shows the interest rate on three-month treasury bills, a good
measure of the nominal interest rate.
The real interest rate adjusts them for changes in the CPI.
In 2009, the real interest rate was above the nominal interest rate. The
change in the CPI was negative then, indicating a rare deflation, or
decline in the price level.

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 Indexing

nominal quantity
The purchasing power of the nominal quantity = price index
 If price index goes up and the nominal quantity keeps constant, then
the purchasing power of the nominal quantity goes down
 One way to prevents the purchasing power of the nominal quantity
from being eroded by inflation is indexing.
Indexing increases a nominal quantity each period by the percent-
age increase in a specified price index
Indexing automatically adjusts certain values, such as social se-
curity payments, by the amount of inflation
 If prices increase 3% in a given year, the social security recipients
receive 3% more
• No action by Congress required
 Indexing is sometimes included in labor contracts

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 Indexed Labor Contract
An indexed labor contract
 First year wage is $12 per hour
• Real wages rise by 2% per year for next 2 years
 Relevant price index is 1.00 in first year, 1.05 in the second, and
1.10 in the third
Nominal wage is real wage times the price index
How to calculate it?
nominal wage in year 1
1 real wage in year 1 = price index in year 1
nominal wage in year 2
2 real wage in year 2 = price index in year 2
| {z }
(real wage in year 1)×(1+2%)

⇒ nominal wage in year 2 = (real wage in year 1) × (1 + 2%) × price index in year 2

Year Real Wage Price Index Nominal Wage

1 $12.00 1.00 $12.00
2 $12.24 1.05 $12.85
3 $12.48 1.10 $13.73

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 Indexing Avoids Distortions

Bracket creep occurs when a household is moved into a higher

tax bracket due to increases in nominal but not real income
 Higher tax brackets have a higher tax rate. For example,

Tax Rate Nominal Income

10% ≤ $ 10,000
15% > $ 10,000

Consider a case without indexing (the base year is year 1)

Period Nominal Income Price level Nominal Income After Tax Real Income After Tax

Year 1 10,000 1.0 10,000 × (1-10%) = 9000 9000/1.0 = 9000

Year 2 11,000 1.1 11,000 × (1-15%) = 9350 9350/1.1 = 8500

 The real income after tax is smaller in year 2 than in year 1.

Income taxes can be indexed to avoid bracket creep

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 Issues with CPI-Inflation

There are several potential issues associated with using CPI-Inflation

as a measure of changes in living costs. These issues include:
Increase in quality bias
New product bias
Substitution bias
Outlet bias

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 Increase in Quality Bias

One important bias in the CPI is no adjustment for quality

 If the price of a computer increases by 20% as a result of the up-
graded hardware
 If no adjustment is made for quality, computer’s contribution to the
CPI will be 20%
• So the increase in CPI in this case reflect the increase in quality
• But not the same computer
Adjusting for quality is difficult
 Large numbers of goods
 Subjective differences

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 New Product Bias

When we calculate the price level, we fix the basket of goods and
services in a base-year
For example, in the U.S., the BLS used to change the basket of
goods only every 10 years.
Now it updates every 2 years.
There is a delay to including new goods like cell phones.
Incorporating new goods is difficult
No base year price for this year’s new goods

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 Substitution Bias – Relative Prices

The price level is a measure of the overall level of prices at a

particular point in time
 Measured by a price index such as the CPI
The relative price of a specific good is a comparison of its price to
the prices of other goods and services
 Calculated as a ratio
 Suppose we have a one-time doubling of the gas price
· Overall price level and inflation increase by a small amount
· The increase in the relative price of gasoline is large
Relative prices can change markedly without corresponding changes
in CPI
Term Price in Base Year Price in Year 1 Price in Year 2
Coffee (1 cup) 1 0.5 1.5
Tea (1 cup) 1 1.5 0.5
Relative Price 1/1 1/3 3/1

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 Substitution Bias

Example: base year cost of market basket

(assume that people don’t have a taste difference between coffee
and tea.)
Item 2015 price 2015 Spending
Coffee (50 cups) $1.00 $50.00
Tea (50 cups) $1.00 $50.00
Total $100.00
CPI uses a fixed basket of goods and services
 When the price of a good increases, consumers buy less and sub-
stitute other goods
 Failing to account for substitution overstates inflation

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 Substitution Bias (Conti.)
In 2020, coffee is more expensive
 If buying exactly the same basket of goods costs
Item 2020 price 2020 Spending
Coffee (50 cups) $2.00 $100.00
Tea (50 cups) $1.00 $50.00
Total $150.00
 CPI = 150 / 100 = 1.50
Actually, consumer substitutes tea for coffee
Item 2020 price 2020 Spending
Coffee (0 cups) $2.00 $0.00
Tea (100 cups) $1.00 $100.00
Total $100.00
True “cost of living” for consumer is 100 / 100 = 1.00
CPI estimate of 150 is 50% higher than consumer’s experience
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 Outlet Bias

CPI used to only survey prices at traditional retail outlets.

 People can buy goods from other places (online store?) at cheaper
prices.
Now BLS tries to minimize this bias by surveying people about
where they actually buy products.

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 Inflation may be Overstated

Economists believe the CPI overstates true inflation by 0.5 to 1 per-

centage point. There are some consequences:
Unnecessarily increases government spending
 Recall the indexing social security payments
Underestimates increase in the standard of living
Real GDP Growth Rate
| {z }
= Nominal GDP Growth Rate − Price
|
Level Growth Rate
{z }
Growth in Standard of Living Inflation

Government (such as BLS) makes great efforts to improve CPI calcu-

lations

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 Does Inflation Impose Costs on the Economy?

Sometimes inflation seems unimportant. If inflation is anticipated, and

If all prices (including wage) doubled overnight, it seems like noth-

ing much would change: the prices of goods and services would
have doubled, but so would your wage.
So you could afford exactly as much as before.
Nominal Wage Nominal Wage × 2
= = Real Wage
Price Level Price Level × 2

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 The Problem with Anticipated Inflation
Even if inflation is anticipated, it still causes problems:
Not all prices and wages rise at the same rate.
 Particularly for people on fixed nominal incomes, inflation can seem
unfair, as the purchasing power of their income falls. So some peo-
ple will see their real wage decrease due to inflation
 Firms have menu costs: the cost to firms of changing prices. Fre-
quently changing prices are inconvenient for firms (and consumers
too!) to deal with.
People and firms have increased real costs of holding cash. (The
cash that they hold will decrease in value.)
 When inflation is high, cash loses value over time
 Manage cash balances to limit losses
• More frequent, smaller withdrawals cost consumers and businesses
time, travel – a real cost of inflation
• Banks process more transactions, increasing costs – another real cost
of inflation
• Costs of managing cash holding are called “shoe-leather” costs, re-
ferring to the cost of frequent trips to the bank

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 The Problem with Unanticipated Inflation
Unexpected inflation redistributes wealth
Suppose workers’ salaries are not indexed and inflation is higher
than anticipated
 Salaries lose purchasing power
 Employers gain at the expense of workers
Unexpected inflation benefits borrowers and hurts lenders
 For a given nominal interest rate, the higher the inflation rate, the
lower the real interest rate: recall

Real Interest Rate = Nominal Interest Rate − Inflation Rate

 Unexpected inflation may not hurt lenders if they can adjust the nom-
inal interest rates
• Inflation-protected bonds pay a real rate of interest plus the inflation
rate
• The Fisher effect is the tendency for nominal interest rates to be high
when inflation is high and low when inflation is low

i =r +π

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 Noisy Prices

If there is no inflation or only minimal inflation:

 When sellers witness an increase in the prices of their goods, they
are likely to raise the prices in order to attain higher profits
 When buyers notice an increase in the prices of goods they con-
sume, they tend to reduce their consumption of these goods
Inflation creates noise in the communication
 Buyers and sellers can’t easily tell whether
• The relative price of this good is increasing OR
• Inflation is increasing the price of this good and all others
 Deciding these issues requires market participants gather informa-
tion – at a cost
 Response to changing prices is tentative and slow

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 Hyperinflation
Hyperinflation is an extremely high rate of inflation
In October 1923, German had a monthly inflation rate of approxi-
mately 29,500 percent

The costs of inflation will be significant

Minimize your cash holding
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 Interference with Long-Term Planning

Some decisions have a long time horizon

 Erratic inflation (high volatility) makes planning risky
Retirement planning requires an estimated cost for your desired
life-style
 Save too little and you live less well in the future
 Save too much and you live less well now
Given the costs of inflation, most economists agree that low and
stable inflation promotes a healthy economy

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 Quiz 1

The consumer price index for the current year measures the cost of
a standard basket in the year relative to the cost of the same
basket in the year.
A) current; base
B) current; current
C) base; index
D) base; current

Quizzes

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 Quiz 1

The consumer price index for the current year measures the cost of
a standard basket in the year relative to the cost of the same
basket in the year.
A) current; base
B) current; current
C) base; index
D) base; current

Answer: (A); The consumer price index compares the cost of a stan-
dard basket of goods and services in any period relative to the cost of
the same basket of goods and services in the base year.

Quizzes

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 Quiz 2

If the total expenditures of a typical family equaled $35,000 per year in

2018 and the exact same basket of goods and services cost $40,000
in the year 2020, the family’s cost of living
A) increased by 14 percent.
B) decreased by 12.5 percent.
C) decreased by 14 percent.
D) increased by 12.5 percent.

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 Quiz 2

If the total expenditures of a typical family equaled $35,000 per year in

2018 and the exact same basket of goods and services cost $40,000
in the year 2020, the family’s cost of living
A) increased by 14 percent.
B) decreased by 12.5 percent.
C) decreased by 14 percent.
D) increased by 12.5 percent.

Answer: (A); The percentage change in the CPI is computed by taking

the current price of the basket divided by the historic price of the basket
and then subtracting 1. In this case, ($40,000/$35,000) - 1 = 0.143, or
a 14 percent increase.

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 Quiz 3

The typical family on the Planet Econ consumes 10 pizzas, 7 pairs of

jeans, and 20 gallons of milk. In 2019, pizzas cost $10 each, jeans
cost $40 per pair, and milk cost $3 per gallon. In 2020, the price
of pizzas increased to $14 each, while the price of jeans and milk
remained the same. Between 2019 and 2020, a typical family’s cost of
living
A) increased by 9 percent.
B) decreased by 9 percent.
C) remained the same.
D) increased by 40 percent.

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 Quiz 3

The typical family on the Planet Econ consumes 10 pizzas, 7 pairs of

jeans, and 20 gallons of milk. In 2019, pizzas cost $10 each, jeans
cost $40 per pair, and milk cost $3 per gallon. In 2020, the price
of pizzas increased to $14 each, while the price of jeans and milk
remained the same. Between 2019 and 2020, a typical family’s cost of
living
A) increased by 9 percent.
B) decreased by 9 percent.
C) remained the same.
D) increased by 40 percent.

Answer: (A); The market basket cost in 2019 was (10 × $10) + (7 ×
$40) + (20 × $3) = $440. The same market basket’s cost in 2020 was
(10 × $14) + (7 × $40) + (20 × $3) = $480, so the consumer price
index is 1.091, or an increase of 9.1 percent.

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 Quiz 4

A consumer expenditure survey reports the following information on

consumer protein spending:

2019 2020
Price Quantity Price Quantity
Fish $5 5 $5 7
Chicken $3 10 $3 12
Beef $6 7 $6 10

Using 2019 as the base year, by how much does a “cost of protein”
index increase between 2019 and 2020?
A) 0.0 percent
B) 8.6 percent
C) 13.4 percent
D) 14.3 percent

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 Quiz 4
A consumer expenditure survey reports the following information on
consumer protein spending:

2019 2020
Price Quantity Price Quantity
Fish $5 5 $5 7
Chicken $3 10 $3 12
Beef $6 7 $6 10

Using 2019 as the base year, by how much does a “cost of protein”
index increase between 2019 and 2020?
A) 0.0 percent
B) 8.6 percent
C) 13.4 percent
D) 14.3 percent
Answer: (A); First, note that in the computation of the CPI, the basket of goods and services is fixed
so the quantities remain the same as in the base year. The protein cost in 2019 was (5 × $5) + (10
× $3) + (7 × $6) = $97. Protein cost in 2020 was (5 × $5) + (10 × $3) + (7 × $6) = $97, so the
protein price index is 1, or an increase of 0.0 percent.

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 Quiz 5

The CPI in year 1 equaled 1.55. The CPI in year 2 equaled 1.64. The
rate of inflation between years 1 and 2 was percent.
A) 4.0
B) 5.8
C) 6.4
D) 9.0

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 Quiz 5

The CPI in year 1 equaled 1.55. The CPI in year 2 equaled 1.64. The
rate of inflation between years 1 and 2 was percent.
A) 4.0
B) 5.8
C) 6.4
D) 9.0

Answer: (B); The percentage change in CPI is calculated as: (current

price index - historic prices) / historic price index. In this case: (1.64 -
1.55) / 1.55 = 0.058, or 5.8 percent.

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 Quiz 6

A college graduate in 1972 found a job paying $7,200. The CPI was
0.418 in 1972. A college graduate in 2016 found a job paying $35,000.
The CPI was 2.40 in 2016. The 1972 graduate’s job paid in
nominal terms and in real terms than the 2016 graduate’s job.
A) more; less
B) more; more
C) less; more
D) less, less

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 Quiz 6

A college graduate in 1972 found a job paying $7,200. The CPI was
0.418 in 1972. A college graduate in 2016 found a job paying $35,000.
The CPI was 2.40 in 2016. The 1972 graduate’s job paid in
nominal terms and in real terms than the 2016 graduate’s job.
A) more; less
B) more; more
C) less; more
D) less, less

Answer: (C); The 1972 graduate’s job paid less in nominal terms
($7,200 is clearly less than $30,000) but more in real terms. The real
wage for the 1972 graduate was $17,225 ($7,200/0.418) compared to
$14,583 ($35,000/2.40) for the 2016 graduate.

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 Quiz 7

A report indicated that the average real wage in manufacturing de-

clined by 2 percent between 1990 and 2000. If the CPI equaled 1.26
in 1990 and 1.63 in 2000, and the average nominal wage in manu-
facturing was $23 in 2000, what was the average nominal wage in
manufacturing in 1990?
A) $29.16
B) $14.11
C) $17.42
D) $18.14

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 Quiz 7
A report indicated that the average real wage in manufacturing de-
clined by 2 percent between 1990 and 2000. If the CPI equaled 1.26
in 1990 and 1.63 in 2000, and the average nominal wage in manu-
facturing was $23 in 2000, what was the average nominal wage in
manufacturing in 1990?
A) $29.16
B) $14.11
C) $17.42
D) $18.14

Answer: (D); The real wage in 2000 was $14.11 (= $23/1.63). This
real wage is 98 percent, or (0.98), of the real wage in 1990. So, the
real wage 2000 = real wage 1990 × 0.98, or 14.11 = real wage 1990
× 0.98. We solve for the real wage in 1990, by dividing each side with
0.98: $14.11/0.98 = 14.40. Finally, we can obtain the nominal wage for
1990 by multiplying the real wage in 1990 with the CPI in 1990: 14.40
× 1.26 = $18.14.
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 Quiz 8

Because the minimum wage is not indexed to inflation, when there is

inflation the nominal minimum wage , and the real minimum wage
.
A) remains constant; decreases
B) remains constant; remains constant
C) decreases; remains constant
D) increases; decreases

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 Quiz 8

Because the minimum wage is not indexed to inflation, when there is

inflation the nominal minimum wage , and the real minimum wage
.
A) remains constant; decreases
B) remains constant; remains constant
C) decreases; remains constant
D) increases; decreases

Answer: (A); Income that is not indexed to inflation loses purchasing

power over time when inflation occurs. In the case of the minimum
wage, it is constant in nominal terms but decreases in real terms.

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 Quiz 9

A labor contract provides for a first-year wage of $10 per hour, and
specifies that the real wage will rise by 3 percent in the second year of
the contract. The CPI is 1.00 in the first year and 1.07 in the second
year. What dollar wage must be paid in the second year?
A) $10.30
B) $10.70
C) $10.90
D) $11.02

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 Quiz 9

A labor contract provides for a first-year wage of $10 per hour, and
specifies that the real wage will rise by 3 percent in the second year of
the contract. The CPI is 1.00 in the first year and 1.07 in the second
year. What dollar wage must be paid in the second year?
A) $10.30
B) $10.70
C) $10.90
D) $11.02

Answer: (D); To find the indexed wage in year 2, the wage that would
maintain the purchasing power from the first year, take the nominal
wage in year 1 and multiply it by the CPI: $10 × 1.07 = $10.70. Then,
since the contract calls for an increase in the real wage by 3 percent,
the indexed wage must be increased by 3 percent: $10.70 × 1.03 =
$11.02.

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 Quiz 10

Suppose manufacturers introduce a new model car to replace a car

currently included in the CPI basket. The price of the new car is 10
percent higher than the discontinued model, but the new car has addi-
tional safety features and amenities. In this situation the CPI will tend
to inflation as a result of bias.
A) overstate; substitution
B) understate; quality adjustment
C) accurately measure; substitution
D) overstate; quality adjustment

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 Quiz 10

Suppose manufacturers introduce a new model car to replace a car

currently included in the CPI basket. The price of the new car is 10
percent higher than the discontinued model, but the new car has addi-
tional safety features and amenities. In this situation the CPI will tend
to inflation as a result of bias.
A) overstate; substitution
B) understate; quality adjustment
C) accurately measure; substitution
D) overstate; quality adjustment

Answer: (D); The CPI did not fully reflect the higher quality of the
new car, so it overstated the price increase. This is called “quality
adjustment” bias.

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 Quiz 11

When statisticians fail to allow for the possibility that consumers switch
from products with rising prices to those whose prices are stable or
falling, it results in
A) quality bias
B) new product bias
C) outlet bias
D) substitution bias

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 Quiz 11

When statisticians fail to allow for the possibility that consumers switch
from products with rising prices to those whose prices are stable or
falling, it results in
A) quality bias
B) new product bias
C) outlet bias
D) substitution bias

Answer: (D); When prices rise sharply for a product, consumers shift
away from it. Since the CPI uses a fixed basket of goods and services,
this switching between substitute products is often missed, resulting in
substitution bias and overstatement of the CPI.

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 Quiz 12

If workers and employers agree to a three-year wage contract under

the expectation of 3 percent inflation, and inflation turns out to be 5
percent, then
A) workers gain and employers gain.
B) workers gain and employers lose.
C) workers lose and employers gain.
D) workers lose and employers lose.

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 Quiz 12

If workers and employers agree to a three-year wage contract under

the expectation of 3 percent inflation, and inflation turns out to be 5
percent, then
A) workers gain and employers gain.
B) workers gain and employers lose.
C) workers lose and employers gain.
D) workers lose and employers lose.

Answer: (C); Workers lose because their wages just went up 3 per-
cent per year whereas average prices went up 5 percent, so their real
incomes fell

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