Short Answer 6: Measuring the Cost of Living
Short Answer
1. What are the steps followed by the Bureau of Labor Statistics in constructing the consumer price index?
2. In a simple economy, people consume only 2 goods, food and clothing:
food          clothing
2000 price                $4              $10
2000 quantity            50              100
2001 price              $10              $15
2001 quantity            50              100
a. What is the percentage increase in the price of food and in the price of clothing?
b. What is the percentage increase in the overall price level?
c. Do these price changes affect all consumers to the same extent? Explain.
3. Suppose that the price of luxury yachts and the price of mid-priced automobiles both increased by 5 percent. Which price increase would have
the larger effect on the CPI? Explain.
4. Which is likely to have the larger effect on the CPI, a 3 percent increase in housing costs or a 3 percent increase in medical costs? Explain.
5. What are the three major problems in using the CPI as a measure of the cost of living?
6. In 1970, Lyle bought a hand calculator for $200. The calculator was more accurate in its four functions of addition, subtraction, multiplication,
and division than was Lyle's $35 slide rule. In 1990, Lyle could not buy a calculator that could only perform four functions. The simplest calculator he could find cost $5, and was much superior to his 1970 calculator. The CPI in 1970 was 100, and in 1990 it was 250.
a. Based on the CPI, what was the value of the 1990 calculator in 1970 dollars?
b. By how much had the price of the calculator fallen in real terms from 1970 to 1990?
c. What problems in the use of the consumer price index as a measure of the cost of living does this story illustrate?
7. Which problems in the construction of the CPI are illustrated by each of the following? Explain your answer.
a. The invention of Atari, the first video game.
b. An increase in the price of Cheerios breakfast cereal, resulting in an increase of consumer expenditures on Wheaties.
c. Increases in the speed of computers.
d. The development and sale of electric heating in homes in response to higher prices of heating oil and natural gas.
8. What are the differences between the CPI and the GDP deflator?
9. If the price of imported Canadian sweaters increases, what will be the likely effects on the CPI and the GDP deflator?
10. If the price of imported Russian mining trucks increases, what will be the impact on the CPI and on the GDP deflator?
11. For each of the following changes, indicate whether the CPI or the GDP deflator is likely to be affected the most.
a. The price of Chevrolet cars falls.
b. The price of U.S. coal-mining machines increases.
c. The price of Italian oil tankers increases.
d. The price of imported English wool sweaters falls.
12. Will an increase in the price of pizzas sold in restaurants cause a relatively larger increase in the CPI or in the GDP deflator?
13. Why does the GDP deflator give a different rate of inflation than does the CPI?
14. What is meant by indexation, and what are some examples of indexation in the U.S. economy?
15. People in northern states spend more on house heating than do people in southern states. If prices of heating oil and natural gas increase, and
Social Security payments are indexed by the CPI, what happens to the relative economic well-being of Social Security recipients in northern and southern states?
16. Why do you suppose that U.S. federal income tax brackets are now indexed for inflation?
17. Can the real interest rate be negative? Explain.
18. Henry and Ellen meet George, the banker, to work out the details of a loan. George, Ellen, and Henry all expect that inflation will be 5 percent
over the term of the loan, and they agree on a nominal interest rate of 10 percent. In actuality, the inflation rate is 8 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?
19. Les buys a house in 1998. He obtains a fixed 10 percent mortgage interest rate, and makes payments of $1,000 per month. The 1998 CPI is 90,
the 1999 CPI is 90, the 2000 CPI is 100, the 2001 CPI is 110, and the 2002 CPI is 120.
a. What is the real mortgage interest rate Les pays in 1999, 2000, and 2001, and 2002?
imported foodb. What are the values in 1998 dollars of Les's monthly mortgage payments in 1999, 2000, 2001, and 2002?
(c) 2001 by Harcourt, Inc. All rights reserved.
ANSWER KEY FOR TEST - SHORT6
1. (1) Fix the basket of goods and services to represent the purchases of a typical consumer.
(2) Find the prices for each of the goods and services in the basket for each point in time.
(3) Use the data on prices to calculate the cost of the basket of goods and services at different times.
(4) Designate one year as the base year and calculate the index.
Chapter:11      QUESTION:189
2. a. The price of food increased by 150 percent. The price of clothing increased by 50 percent.
b. It cost consumers a total of $1,200 to purchase 50 units of food and 100 units of clothing in 2000. In 2001, it cost consumers $2,000 to
buy the same amounts as in 2000. Therefore, the overall price level increased by 67 percent ($800/$1,200).
c. Since the price of food increased relatively more than did the price of clothing, people who purchase a lot of food and little clothing
became worse off relative to people who purchase a lot of clothing and little food.
Chapter:11      QUESTION:190
3. The 5 percent increase in the price of the mid-priced automobiles would have the larger effect on the CPI since consumers typically buy many
more mid-priced automobiles than luxury yachts, hence the weight in the CPI for mid-priced automobiles is much larger than the weight for luxury yachts.
Chapter:11      QUESTION:191
4. The 3 percent increase in housing costs will have a larger impact on the CPI than will the 3 percent increase in medical costs, since housing
costs represent about 40 percent of a typical consumer's budget, while medical costs represent less than 10 percent.
Chapter:11      QUESTION:192
5. (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.
Chapter:11      QUESTION:193
6. a. The value of the 1990 calculator in 1970 prices was $5 ð (100/250) = $2.
b. The price of the calculator had fallen by 99 percent from 1970 to 1990.
c. The invention of the calculator illustrates the problem of the introduction of new goods that improve well-being but are not included in
the CPI basket of goods. The improvement in the quality of the calculator over time might not be measured, particularly since it was not possible by 1990 to buy a calculator as simple as the 1970 model. Also, the large initial decline in the price of calculators would not be accounted for in the index, since the basket of goods is updated only every few years.
Chapter:11      QUESTION:194
7. a. The invention of Atari improved the well-being of consumers by offering a new kind of entertainment, but was not reflected in the
fixed-basket CPI.
b. The fixed-basket CPI does not take into account the substitution of Wheaties for Cheerios as the price of Cheerios increases.
c. Increases in the speed of computers represents an improvement in quality, which may not be entirely measured in the CPI.
d. The development of a new product improves consumer well-being but is not included in the fixed baskets of goods and services, hence,
is not measured by the CPI. In addition, the substitution of cheaper electric heating for more expensive alternatives is not taken into account by the CPI.
Chapter:11      QUESTION:195
8. The GDP deflator reflects the prices of all final goods and services produced in the economy, while the CPI reflects the prices of goods and
services purchased by typical consumers. Also, the GDP deflator uses a variable basket of goods and
servicesÄÄthose produced in the current year, while the CPI uses a fixed basket of goods and servicesÄÄthose purchased in the base year.
Chapter:11      QUESTION:196
9. The CPI will increase, because imported Canadian sweaters are part of the purchases of a typical consumer. However, the GDP deflator will
be unaffected because it reflects only the prices of domestically produced goods and services.
Chapter:11      QUESTION:197
10. Neither the CPI nor the GDP deflator will increase. The CPI includes only consumer goods, and the mining trucks are capital goods. The
GDP deflator includes only domestically produced goods, and the mining trucks are imported.
Chapter:11      QUESTION:198
11. a. CPI falls more than GDP deflator.
b. CPI is unaffected, but GDP deflator increases.
c. CPI and GDP deflator are both unaffecte
d.
d. CPI falls, but GDP deflator is unaffected.
Chapter:11      QUESTION:199
12. Because pizzas make up a larger fraction of consumer expenditures than they do of GDP, the price increase will cause the CPI to increase
relatively more than the GDP deflator.
Chapter:11      QUESTION:200
13. 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 cons
umers. 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.
Chapter:11      QUESTION:201
14. Indexation refers to the automatic correction of dollar amounts for inflation by law or contract. Examples in the U.S. economy include
COLAS, indexation of Social Security benefits, and indexation of federal income tax brackets.
Chapter:11      QUESTION:202
15. Since the CPI reflects the purchases of natural gas and heating oil of typical consumers, Social Security recipients in northern states will find
that their economic well-being has decreased relative to the economic well-being of Social Security recipients in southern states. Since the CPI overestimates the cost of living, both groups may actually
be better off after the increase in oil and gas prices. Certainly, the southern group will be better off.
Chapter:11      QUESTION:203
16. The federal income tax brackets are indexed because without indexation, inflation causes people's income to be pushed into income tax
brackets with higher marginal rates, increasing their real taxes. People complained about this, and their elected representatives changed the tax laws.
Chapter:11      QUESTION:204
17. The real interest rate is the nominal interest rate minus the rate of inflation. If the rate of inflation is greater than the nominal interest rate, the
real interest rate is negative.
Chapter:11      QUESTION:205
18. a. The expected real interest rate was 5 percent.
b. The actual real interest rate was 2 percent.
c. George, the banker lost because he receives less real interest income than he expecte
d. Henry and Ellen gain because they pay less real
interest income than they expected.
Chapter:11      QUESTION:206
19. a. The real mortgage interest rate in 1999 is 10 percent, in 2000 is -1 percent, in 2001 is 0 percent and in 2002 is 1 percent.
b. Les's 1999 payment in 1998 dollars is $1,000, his 2000 payment in 1998 dollars is $900, his 2001 payment in 1998 dollars is $818, and
his 2002 payment in 1998 dollars is $750.
Chapter:11      QUESTION:207
(c) 2001 by Harcourt, Inc. All rights reserved.

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