Page 513 - The Principle of Economics

consumer price index (CPI), p. 512 producer price index, p. 515 nominal interest rate, p. 523 inflation rate, p. 514 indexation, p. 521 real interest rate, p. 523
CHAPTER 23 MEASURING THE COST OF LIVING 525
N Various laws and private contracts use price indexes to correct for the effects of inflation. The tax laws, however, are only partially indexed for inflation.
N A correction for inflation is especially important when looking at data on interest rates. The nominal interest rate is the interest rate usually reported; it is the rate at
which the number of dollars in a savings account increases over time. By contrast, the real interest rate takes into account changes in the value of the dollar over time. The real interest rate equals the nominal interest rate minus the rate of inflation.
Key Concepts
Questions for Review
1. 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?
2. Describe the three problems that make the consumer price index an imperfect measure of the cost of living.
3. If the price of a Navy submarine rises, is the consumer price index or the GDP deflator affected more? Why?
4. Over a long period of time, the price of a candy bar rose from $0.10 to $0.60. Over the same period, the consumer price index rose from 150 to 300. Adjusted for overall inflation, how much did the price of the candy bar change?
5. Explain the meaning of nominal interest rate and real interest rate. How are they related?
Problems and Applications
1. Suppose that people consume only three goods, as shown in this table:
they buy 100 heads of cauliflower for $200, 50 bunches of broccoli for $75, and 500 carrots for $50. In 2002 they buy 75 heads of cauliflower for $225, 80 bunches of broccoli for $120, and 500 carrots for $100. If the base year is 2001, what is the CPI in both years? What is the inflation rate in 2002?
From 1947 to 1997 the consumer price index in the United States rose 637 percent. Use this fact to adjust each of the following 1947 prices for the effects of inflation. Which items cost less in 1997 than in 1947 after adjusting for inflation? Which items cost more?
TENNIS TENNIS
BALLS RACQUETS
GATORADE
2001 price $2 $40 $1 2001 quantity 100 10 200
3.
2002 price $2 $60 2002 quantity 100 10
$2 200
a. What is the percentage change in the price of each of the three goods? What is the percentage change in the overall price level?
b. Do tennis racquets become more or less expensive relative to Gatorade? Does the well-being of some people change relative to the well-being of others? Explain.
2. Suppose that the residents of Vegopia spend all of their income on cauliflower, broccoli, and carrots. In 2001
ITEM
University of Iowa tuition Gallon of gasoline Three-minute phone call
from New York to L.A. One-day hospital stay in
intensive care unit McDonald’s hamburger
1947 PRICE
$130 $0.23
$2.50
$35 $0.15
1997 PRICE
$2,470 $1.22
$0.45
$2,300 $0.59