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Multiple Choice Questions 1. The price index used to calculate most cost-of-living adjustments is the: a. consumer price index. b. producer price index. c. GDP deflator. d. NDP deflator. Answer: a 2. The consumer price index is computed by comparing the cost of the typical market basket of goods purchased during a base year (evaluated at base year prices) with: a. The cost of the same market basket evaluated at current prices. b. The cost of the current market basket evaluated at base-year prices. c. The cost of the current market basket evaluated at current prices. d. The cost of the same market basket evaluated at base year prices. Answer: a 3. A price index in years after the base year: a. Is never 100. b. Is always greater than 100. c. Is always less than 100. d. Can be less than, greater than, or equal to 100. Answer: d 4. If the CPI increased from 80 to 84, the rate of inflation is: a. 4 percent. b. 5 percent. c. 10 percent. d. 20 percent. Answer: b 5. In 1969, the United States CPI was 37 (1982-84=100) and in 1999 it was 166. From these figures we can conclude that in the United States prices increased about ______ percent between 1969 and 1999. a. 80 b. 125 c. 210 d. 350 Answer: d 6. If the consumer price index (CPI) at the end of 1990 was 125 and the CPI at the end of 2000 was 133, then the rate of inflation over the time period was: a. zero (prices were stable during this period). b. 4.8 percent. c. 6.4 percent. d. 8 percent.

Answer: c 7. Unexpected inflation will: a. Hurt borrowers. b. Hurt lenders. c. Hurt borrowers and lenders equally. d. Have no effect on either borrowers or lenders. Answer: b

Discussion Questions: What is the difference between CPI and GDP deflator? Can you give example of the pros and cons of each index? Answer: The CPI calculates the cost of a certain basket of consumer goods and services. Each month, the BLS does surveys in many store across the country in order to get information on price for goods and service a typical consumer purchase. Inflation is computed as a percentage change in the coast of the basket of good. GDP Deflator is used to calculate real GDP. Note that while a fixed basket of goods and services is used in calculating the CPI, the GDP deflator is measured using the set of final goods and services that is actually produced in the economy in a given time period. The fixed basket used in CPI calculations is static and sometimes misses changes in prices outside of the basket of goods. This makes the GDP deflator a superior indicator of inflation. Since GDP isn't based on a fixed basket of goods and services, changes in consumption patterns or the introduction of new goods and services are automatically reflected in the deflator. Hence, the GDP deflator to capture any changes to an economy's consumption or investment patterns. Note: trends of the GDP deflator will often be similar to trends in the CPI. Accuracy of CPI: - Substitution: CPI does not take into account the fact that consumer substitute between goods, hence basket of goods and services should not be fixed). - Change in quality: quality of good generally increase which eventually increase price. Hence change in price might not always be due to inflation but sometimes to improvement in quality. Ex: Cellphones or computer now vs. in the past. - New goods, services, and locations: new goods and services are always introduced so that basket of goods and services does not always reflect actual basket of goods and services used by a typical consumer.

Long Problem Suppose the economy of UVA produces 5 goods, but only cherries, chocolate, and ice cream are consumer goods. Woods and coal are also final goods, but are not bought by consumers. The total production of all goods is given in the following table followed by their respective prices: Items

Cherries Chocolate Ice cream Wood Coal

2000 Quantity Price $ 8 10 12 5 11

4 3 2 8 4

Years 2001 2002 Quantity Price $ Quantit Price $ y 9 6 10 6 15 3 15 4 13 3 15 3 6 8 8 9 13 5 14 5

2003 Quantit Price $ y 15 7 20 5 17 4 10 9 16 6

Using these data, answer the following questions: a) Taking 2000 as the base year, compute the cost of the consumption basket for years 2000 through 2003. b) Compute the CPI for each year. c) Compute the rate of inflation based on the CPI for all years d) Compute the nominal GDP for each year. e) Compute the real GDP for each year f) Compute GDP deflators for all years g) Compute the rate of inflation based on the GDP deflator for all years. h) Compare the inflation rates you’ve calculated based on the CPI and the GDP deflator. How do you explain the differences? i) Compute the price for cherries for 2000, 2001, and 2002 in 2003 dollars j) Compute the price for cherries for 2001, 2002, and 2003 in 2000 dollars k) For part i and j, comment on the difference in prices compared to each year actual price. l) The following table gives the aggregate nominal income of middle class citizens in this economy. In which year did they have the highest well-being? Comment

Year

2000

2001

2002

2003

Income

$90

$155

$185

$230

Answers

Years

2000

2001

2002

2003

Cost of the consumption basket ($)

86

114

124

154

CPI

100

132.56

144.19

179.06

Rate of inflation based on the CPI (%)

-

32.56

8.77

24.21

Nominal GDP ($)

170

251

307

459

Real GDP ($)

170

207

235

298

GDP Deflator

100

121.25

130.63

154.02

Rate of inflation based on the GDP deflator (%)

-

21.25

7.73

17.90

Cost of Consumption Basket: We use 2000 quantity as the base quantity. This is because CPI is a measure of the price level based on the consumption pattern of a typical consumer (“fixed” basket of good) ----Thanks to everyone who pointed this out! So to compute CPI, we multiply the current year price by the base year (2000) quantity and we sum over the goods. Note that for the consumption basket, we only need cherries, chocolates, and ice cream since those are the consumer goods. For example, Cost of Consumption Basket in 2002 = (8*6)+(10*4)+(12*3) = 124 CPI = (Basket price / Basket price in the base year) *100

For example, CPI for 2003 = (154/86)*100 = 154 Note: Real GDP is GDP evaluated at the market prices of the base year. So, for the purpose of this exercise we will use this definition. Hence to compute real GDP for each year, we multiply the current quantity by the price of the base year and we sum it across all the goods for that specific year. For example, real GDP for 2001 = (9*4+15*3+13*2+6*8+13*4 = 207) GDP Deflator = (Nominal GDP / Real GDP) * 100 For example, GDP Deflator for 2002 is (307/235)*100 = 130.63

i) Price for cherries for 2000, 2001, and 2002 in 2003 dollars Price in today dollars = Price in earlier time * (price level today / Price level in earlier time) For 2000: 7.16 For 2001: 8.10 For 2002: 7.45

to get this you do 4 * (179.07/100)

j) Price for cherries for 2001, 2002, and 2003 in 2000 dollars Price in earlier time = Price in today dollars * (Price level in earlier time / price level today) For 2001: 4.53 For 2002: 4.16 For 2003: 3.91

to get this you do 6 * (100/132.56)

k) All the difference in price are due to inflation and adjustment in living standards. Notice that when we compute the price for cherries in 2003 dollars, we get a higher price compare to the actual price for each year. On the other hand, when we compute the price for cherries in 2000 dollars, we get a lower price compare to the actual price for each year. l) We will divide total aggregate income by price level for each year and compare. This is the real income.

Year

2000

2001

2002

2003

Income/price level

0.9

1.1692

1.2830

1.2844

We divided income by price level in order to compute the real income which account for the price level. Here we found that they have the highest well-being in 2003.

Note that it is not always the case that having the highest income will mean having the highest well-being. In this exercise it happens that they have the highest income in 2003 and also have the highest well-being in that same year. Suppose the price level for 2003 was actually 200. In that case the real income would have been 230/200 = 1.15. In this case, they would have not had the highest well-being despite having the highest income in this year....