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Auxiliary Problems for Week 5
1. In a Treasury Inflation Protected Security (TIPS), one’s real interest rate is fixed (i.e.,
protected against inflation). How does this differ from a traditional bond?
2. You borrow $15,000 at a fixed nominal interest rate of 7 percent per year. If annual inflation
turns out to be 10 percent, what is the real rate of interest?
3. Home Depot agreed to pay its workers $13 an hour in 2003 and $17 an hour in 2007. The
CPI in 2003 was 196 and 205.5 in 2007. Calculate the real wage in each year. Did their real
wage increase at the same rate as their nominal wage?
4. For the past decade medical care in the U.S. has increased at 7 percent per year. If 2010
expenditures are $7,500 per person, what will expenditures be in two years if growth
continues at the same rate?
5. Suppose for the next 3 years your annual income will be $70,000 and the rate of inflation is
estimated to be 3 percent per year.
a) Find the real value of $70,000 for each of the next 3 years.
b) If inflation were to be 10 percent, what would be the real value of income for the next 3
years?
6. Given the item weights for the following goods, calculate the average rate of inflation over
the past year.
Unit Price
Percent change Item Weight Inflation
impact
Last Year This Year in price
Shoes
$80
$87
0.30
Laptop
$1,500
$1,450
0.50
Lg. Pizza
$16
$19
0.20
Item
Answers
1. In a traditional bond, one’s nominal interest rate is fixed so the real rate cannot be determined
until the bond is redeemed.
2. Real interest rate = nominal interest rate – rate of inflation: 7% - 10% = -3%
3. Real wage in 2003 = (nominal wage in 2003/CPI in 2003)*100. Using this formula, the real
wage in 2003 is $6.63, and in 2007, it rises to $8.27. The real wage increased at a slower
pace than the nominal wage. While the nominal wage increased by 31%, the real wage
increased by only 25%.
4. Future Value of medical expenditures = (Present Value)*(1 + rate of inflation)t.
($7,500)*(1 + 0.07)2 = $8,586.75.
5. a) Year 1 = ($70,000/1.03) = $67,961; Year 2 = ($67,961/1.03) = $65,982;
Year 3 = ($65,982/1.03) = $65,060
b) Year 1 = ($70,000/1.10) = $63,636; Year 2 = ($63,636/1.10) = $57,851;
Year 3 = ($57,851/1.10) = $52,592
6.
Unit Price
Percent change Item Weight Inflation
impact
Last Year This Year in price
Shoes
$80
$87
8.75%
0.30
2.625
Laptop
$1,500
$1,450
-3.33%
0.50
-1.667
Lg. Pizza
$16
$19
18.75%
0.20
3.750
Item
% change in price = (P2 –P1)/P1
Inflation impact = % change price/item weight
Average rate of inflation = 2.625 - 1.667 + 3.750 = 4.71 percent
Multiple-Choice
1. Inflation is
a.
b.
c.
d.
A decrease in the average price level.
A change in relative prices of goods.
An increase in the average price level.
A situation when the price of necessities rises.
Answer: c
Feedback: Prices fluctuate all the time, but inflation occurs when the average
level of goods and services goes up.
price
2. The CPI is not a perfect measure on inflation because
a.
b.
c.
d.
It does not consider imports.
It does not consider medical care.
It does not consider rental charges for property not owned by user (e.g., rental cars).
It does not consider all improvements in the quality of goods.
Answer: d
Feedback: It’s impossible to perfectly correct for the price differences due to changes in
the quality of goods and services. This is especially true if there is a lot of technological
change (e.g., computers).
3. Who is most hurt by inflation?
a.
b.
c.
d.
Investors who buy diamonds and precious metals.
Savers.
Real estate owners.
Borrowers.
Answer: b
Feedback: Savers are generally hurt by inflation, especially if they hold a fixed-rate
security like a certificate of deposit. If the rate of return is 5 percent and inflation is 6
percent, the saver is losing purchasing power by holding the security.
4. Sam suffers from money illusion. This means
a.
b.
c.
d.
He uses credit cards instead of cash.
He calculates his real income before making financial decisions.
His wage has kept up with inflation, but he complains about higher prices.
His wage has not kept up with inflation, and his real income has fallen.
Answer: c
Feedback: Money illusion means that you don’t properly recognize the change
purchasing power of the dollar.
in the
5. Hyperinflation is
a.
b.
c.
d.
A severe recession along with inflation.
An increase in the average price level of 3 percent to 10 percent.
An inflation rate that remains above 200 percent for more than one year.
An increase in the price of goods but not services.
Answer: c
Feedback: Hyperinflation is excessively high inflation. It is detrimental because people
cannot trust the purchasing power of the currency, so they may avoid using currency
altogether.
6. Deflation is not desirable because
a.
b.
c.
d.
Most prices are falling.
It is historically associated with severe recessions.
Many prices cannot be changed.
It results in the money illusion.
Answer: b
Feedback: When deflation occurs, people hoard money. When spending is reduced
because of this hoarding, national income falls.
7. The Consumer Price Index (CPI)
a.
b.
c.
d.
Measures the rate of output in the economy over one year.
Is used to calculate the rate of inflation over a given period.
Measures the increase in wholesale prices since a base year.
Is deficient because it does not include medical prices.
Answer: b
Feedback: The CPI is the most widely used measure of the U.S. inflation rate.
8. If the CPI is 180 for 2003 and the base year is 1982, this means that
a.
b.
c.
d.
Prices went up by 80 percent from 1982 to 2003.
Prices went up by 180 percent from 1982 to 2003.
Prices went up by 280 percent from 1982 to 2003.
Prices went down by 80 percent from 1982 to 2003.
Answer: a
Feedback: The CPI equals the current price level divided by the base year price level,
multiplied by 100. Thus if the base year = 100 and the current year = 180, this means
there was an 80 percent increase in prices over the periods compared.
9. Price stability in the United States is defined as
a.
b.
c.
d.
The absence of hyperinflation.
An inflation rate of 4–5 percent.
A fall in the average price level.
An inflation rate below 3 percent.
Answer: d
Feedback: There is no perfect definition for “price stability,” but a good working
definition is a low inflation rate in the neighborhood of a few percent.
10. Policy makers do not aim for 0 percent inflation because
a.
b.
c.
d.
It results in a fall in unemployment.
It is impossible to achieve.
It may result in higher unemployment.
It would eliminate the ability to change prices.
Answer: c
Feedback: When the economy hovers around 0 percent inflation, there is a risk
deflation will occur and people will start hoarding their money instead of spending it.
that