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©Copyright 2017 by the UBC Real Estate Division
LESSON 5
Inflation: Causes and Measurement
Assigned Reading
1.
Mankiw, N.G., et al. 2014. Principles of Macroeconomics (6th Canadian Edition). Toronto: Nelson
Education Ltd.
Chapter 6: Measuring the Cost of Living
Chapter 11: Money Growth and Inflation
Recommended Reading
1.
Mankiw, N.G., et al. 2014. Study Guide for use with the Principles of Macroeconomics,
(6th Canadian Edition). Toronto: Nelson Education Ltd.
Chapter 6: Measuring the Cost of Living
Chapter 11: Money Growth and Inflation
Learning Objectives
After studying this lesson, students should be able to:
1.
describe how the consumer price index (CPI) is constructed;
2.
explain the three ways the CPI can misrepresent the actual changes in consumers' cost of living;
3.
compare the similarities and differences between the CPI and the GDP deflator as measures of the
overall price level;
4.
use the CPI to measure the "real" change the prices of individual goods, incomes, and production
over time;
5.
explain how to use the CPI to distinguish between real and nominal interest rates;
6.
describe how inflation is a decline in the value of money;
7.
explain why inflation results from a rapid growth in the money supply;
8.
discuss the meanings of the classical dichotomy and monetary neutrality;
9.
explain how the velocity and the quantity equations can help us analyze the quantity theory of
money;
10.
examine what causes a country to experience hyperinflation;
11.
examine how the nominal interest rate responds to the inflation rate; and
12.
consider the various costs and consequences of inflation.
5.1
©Copyright 2017 by the UBC Real Estate Division
Lesson 5
Instructor's Comments
Just as GDP measures the economy's total output of goods and services, the consumer price index (CPI)
measures the cost of living over time. Chapter 6 of the text discusses the CPI, its construction, limitations,
and uses. Chapter 12 analyzes inflation by applying the material presented in Chapter 6. Chapter 12 presents
the causes and effects of inflation, emphasizing the role of the rate of growth of money as the primary
determinant of inflation. This relationship is demonstrated both through a supply and demand model of
money and, under the assumption that the velocity of money is stable, the equation of exchange. In
discussing the effects of inflation, the text highlights that these are not always what they seem. Much of the
true costs of inflation lie in the inefficiencies of trying to survive in an environment with rapidly changing
prices. However, while these costs are clear when inflation is high, there is no consensus on the size of these
costs when inflation is moderate. What is true, even with low rates of inflation, is that inflation can benefit
certain groups over others: debtors tend to benefit from unexpected inflation, while creditors benefit when
the price level declines.
There are tax implications to inflation that favour home ownership over other types of investments. As the
text describes, inflation can cause after-tax real capital gains to fall because investors pay tax on the
increases in the price of their assets that come from inflation. However, in Canada, as in many other
countries, capital gains from a principal residence are protected from taxation (in Canada this protection has
the form of a one-time life exemption, assuming that home owners buy a new home within a certain time
period of selling their old unit). Therefore, an investment in housing represents a tax-free gain and a form of
savings to the owner as compared to investing in equities (assuming house prices are rising). The reason
house prices rise with inflation is that inflation drives up rents. This increase is a second benefit of home
ownership described in Lesson 1: that a home owner's implicit rent is not taxed, while renters do not receive
any tax benefits from rent payments. The value of the favourable tax treatment of implicit rent rises as rents
rise with inflation.
In Lesson 3, we discussed how nominal interest rates can be important for mortgage borrowing. When
inflation is high, the purchasing power of the dollar declines over time, so that a mortgage will be repaid
with increasingly "cheaper" dollars over the life of the mortgage. Most mortgages taken by home owners
have level payments each month; the high rate of inflation means that the real value of these payments will
decline over time. This phenomenon is known as "tilt", because in the presence of inflation, the real
mortgage payments are tilted downward so that they decline over time. The problem with tilt is that this
places a greater burden on the borrower during the early years, so much so that some prospective owners
will be excluded from the market because they do not have sufficient income in the first years of the
mortgage to qualify for it. In countries with high levels of inflation, other mortgage products have been
developed to compensate for this problem, allowing borrowers to take mortgages whose nominal payments
increase over time.
Review and Discussion Questions
1.
What are the three major problems in using the CPI as a measure of the cost of living? Briefly
explain each of these problems.
2.
What are the differences between the CPI and the GDP deflator?
3.
Can the real interest rate be negative? Explain.
5.2
©Copyright 2017 by the UBC Real Estate Division
Inflation: Causes and Measurement
4.
5.
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?
Les buys a house in 2007. He obtains a fixed 10% mortgage interest rate, and makes payments of
$1,000 per month. The 2007 CPI is 90, the 2008 CPI is 90, the 2009 CPI is 100, the 2010 CPI is
110, and the 2011 CPI is 120.
(a)
What is the real mortgage interest rate Les pays in 2008, 2009, 2010, and 2011?
(b)
What are the values in 2007 dollars of Les's monthly mortgage payments in 2008, 2009,
2010, and 2011?
6.
Why do expected and unexpected inflation cause such different effects in the economy?
7.
Who are the winners and losers from inflation?
8.
What is the difference between the nominal rate of interest and the real rate of interest? How are
they related? Think of an instance where the rates would be equal, or the real rate was greater than
the nominal rate.
9.
What does it mean to have your wage "indexed?"
10.
What innovations in the mortgage market have occurred to battle the costs of inflation?
11.
What is monetary neutrality and how is it related to the classical dichotomy?
12.
How can the quantity equation be used to explain hyperinflation?
13.
What is the inflation tax, and how might it explain the creation of inflation by a central bank?
14.
What are the costs of inflation?
15.
Is David Hume's description of the classical dichotomy and monetary neutrality a good description
of the actual economy? Explain.
16.
Ben borrows money to buy a farm in Saskatchewan. When he borrows at a fixed interest rate of
8%, both Ben and the banker expect that inflation will continue at 3% per year in the future. Within
a year after Ben buys the farm, the Bank of Canada reduces the rate of inflation to zero, where it
remains for many years. How does this development affect the economic position of Ben and the
banker?
5.3
©Copyright 2017 by the UBC Real Estate Division
Lesson 5
ASSIGNMENT 5
CHAPTER 6: Measuring the Cost of Living
CHAPTER 11: Money Growth and Inflation
Marks: 1 mark per question.
1.
If a Starbucks Frappuccino costs $4 in 2012 (the base year), $4.50 in 2013 and $5 in 2014, use the
consumer price index to compute the inflation rate from 2013 to 2014.
(1)
(2)
(3)
(4)
2.
Jane deposits $10,000 into a saving account at the first of the year. The saving account pays 5%
interest. There is inflation during the year. Which of the following is a correct statement about
Jane's savings at the end of the year?
(1)
(2)
(3)
(4)
3.
12.5%
11.11%
125
112.5
Jane will earn $500 interest by the end of the year.
When Jane withdraws her principal, she will have $10,500.
Jane will be richer by $500 in real terms.
All of the above are correct statements.
An increase in the price of French wine imported into Canada will be reflected in:
(1)
(2)
(3)
(4)
both the GDP deflator and the consumer price index.
neither the GDP deflator nor the consumer price index.
the GDP deflator but not in the consumer price index.
the consumer price index but not in the GDP deflator.
THE NEXT TWO (2) QUESTIONS ON BASED ON THE FOLLOWING INFORMATION:
George Farmer earns $6,000 from his farm operation in 1950. In 2014, George's grandson Karl earns
$60,000 from the same farm. The price index for 1950 is 10, and the price index for 2014 is 120.
4.
What is George's income equivalent to in 2014?
(1)
(2)
(3)
(4)
5.
$6,000
$50,000
$60,000
$72,000
What is Karl's income equivalent to in 1950?
(1)
(2)
(3)
(4)
$5,000
$6,000
$7,200
$50,000
Assignment 5 continued on the next page
5.4
©Copyright 2017 by the UBC Real Estate Division
Inflation: Causes and Measurement
6.
Which is the most accurate statement about the consumer price index?
(1)
(2)
(3)
(4)
7.
Charlie buys a house in 2012, and finances it with a mortgage that carries an annual interest rate of
5%. Assume that inflation in 2012 is 3%, inflation in 2013 is 7%, and inflation in 2014 is 14%.
What is the real interest rate Charlie pays on his mortgage in 2012?
(1)
(2)
(3)
(4)
8.
menu costs; shoeleather costs
shoeleather costs; menu costs
misallocation of resources; menu costs
misallocation of resources; arbitrary redistributions of wealth
Which is the most accurate statement about the GDP deflator and the consumer price index?
(1)
(2)
(3)
(4)
10.
-2%
2%
5%
10%
Economists have identified several costs of inflation, _________ are the resources wasted when
inflation encourages people to reduce their money holdings and _________ are the costs of changing
prices.
(1)
(2)
(3)
(4)
9.
When the consumer price index increases, the standard of living of the average family
increases.
When the consumer price index increases, the average family has to spend less to maintain
their standard of living.
When the consumer price index increases, the average family has to spend more to maintain
their standard of living.
The consumer price index has nothing to do with the standard of living of the average
family.
Both the GDP deflator and the consumer price index compare the price of a fixed basket of
goods and services to the price of the basket in the base year.
Both the GDP deflator and the consumer price index compare the price of currently
produced goods and services to the price of the same goods and services in the base year.
The GDP deflator compares the price of a fixed basket of goods and services to the price of
the basket in the base year, but the consumer price index compares the price of currently
produced goods and services to the price of the same goods and services in the base year.
The consumer price index compares the price of a fixed basket of goods and services to the
price of the basket in the base year, but the GDP deflator compares the price of currently
produced goods and services to the price of the same goods and services in the base year.
Consumers begin purchasing houses incorporating steel studs instead of wooden studs after the price
of lumber increases. This situation best represents which problem in the construction of the CPI?
(1)
(2)
(3)
(4)
substitution bias
introduction of new goods
unmeasured quality change
All of the above
Assignment 5 continued on the next page
5.5
©Copyright 2017 by the UBC Real Estate Division
Lesson 5
11.
In the long run, if the money supply is increased, the price level will __________ and the quantity
of money demanded will __________.
(1)
(2)
(3)
(4)
12.
Classical dichotomy is the theoretical separation of _______ (variables measured in monetary units)
and _______ (variables measured in physical units).
(1)
(2)
(3)
(4)
13.
debtors, creditors
owners of real property, owners of financial assets
creditors, debtors
the government, fixed income recipients
According to the quantity theory of money, what is the effect of a monetary injection in an economy?
(1)
(2)
(3)
(4)
17.
real wage has not changed.
nominal wage has not changed.
real wage has decreased by 4%.
real wage has increased by 6%.
Unexpected inflation redistributes wealth from __________ to __________.
(1)
(2)
(3)
(4)
16.
increases, increases
increases, decreases
decreases, decreases
decreases, increases
If prices increase by 10% and nominal wages increase by 6%, then the:
(1)
(2)
(3)
(4)
15.
nominal variables; real variables
real variables; nominal variables
nominal variables; relative variables
relative variables; real variables
As the price level increases, the value of money __________ and the demand for money
__________.
(1)
(2)
(3)
(4)
14.
decrease, decrease
increase, increase
decrease, increase
increase, decrease
The monetary injection shifts the supply curve left.
The value of money increases and the equilibrium price level increases.
The value of money decreases and the equilibrium price level increases.
The value of money decreases and the equilibrium price level decreases.
Governments may prefer an inflation tax to some other kind of tax since the inflation tax:
(1)
(2)
(3)
(4)
reduces the real cost of government expenditure.
is hidden, making it less obvious to people that they are being taxed.
reduces inflation.
falls mainly on high-income individuals.
Assignment 5 continued on the next page
5.6
©Copyright 2017 by the UBC Real Estate Division
Inflation: Causes and Measurement
18.
According to the Fisher effect, an increase in the rate of inflation from 3% to 6% will __________
the __________ interest rate by __________ percentage points.
(1)
(2)
(3)
(4)
19.
Based on the quantity equation, if M = 5, V = 20, and Y = 200, then P =
(1)
(2)
(3)
(4)
20.
100
2
1/2
1/100
The interest rate corrected for the effects of inflation is known as the:
(1)
(2)
(3)
(4)
___
20
increase, nominal, 3
increase, real, 3
decrease, nominal, 3
increase, nominal, less than 3
nominal interest rate.
effective interest rate.
inflation rate.
real interest rate.
Total Marks
Planning Ahead
Note that Project 1 is due in two weeks, on the same due date as
Assignment 7. You should be well advanced into the work required for
this project by now.
End of Assignment 5
5.7
©Copyright 2017 by the UBC Real Estate Division