# answerstohomework3spring2007 - Economics 102 Homework#3...

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Economics 102 Homework #3 Spring 2007 Due Tuesday, March 13 in lecture Directions: The homework will be collected in a box before the lecture. Please place your name , TA name and section number on top of the homework (legibly). Make sure you write your name as it appears on your ID so that you can receive the correct grade. Please remember the section number for the section you are registered in, because you will need that number when you submit exams and homework. Late homework will not be accepted so make plans ahead of time. Good luck! 1. In this question you are asked to calculate the CPI and inflation rate in 4 different ways, varying the choice of the market basket and of the base year. Then you are asked to compare the results you calculated. Assume consumers in Badger Land only consume pears and watermelons. The following table provides the quantities produced and prices in 2005 and 2006. 2005 2006 Item Quantity Produced Price Quantity Produced Price Pears 10 \$1 15 \$2 Watermelons 15 \$3 10 \$5 (a) Using the quantities produced in 2005 as the market basket and using 2005 as the base year, calculate the CPI in 2005 and 2006. Calculate the inflation rate between 2005 and 2006. Cost of basket in 2005: 10*1+15*3=\$55; Cost of basket in 2006: 2*10+5*15=\$95; CPI in 2005=100 CPI in 2006= 95/55*100=172.7. Inflation rate= (172.7-100)/100*100%=72.7% (b) Using the quantities produced in 2006 as the market basket and using 2005 as the base year, calculate the CPI in 2005 and 2006. Calculate the inflation rate between 2005 and 2006 Cost of basket in 2005: 1*15+3*10=\$45; Cost of basket in 2006: 2*15+5*10=\$80; CPI in 2005=100 CPI in 200= 80/45*100=177.8. Inflation rate=(177.8-100)/100*100%=77.8% (c) Using the quantities produced in 2005 as the market basket and using 2006 as the base year, calculate the CPI in 2005 and 2006. Calculate the inflation rate between 2005 and 2006.

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CPI in 2005: 55/95*100=57.9 CPI in 2006=100 Inflation rate=(100-57.9)/57.9*100%=72.7% (d) Using the quantities produced in 2006 as the market basket and using 2006 as the base year, calculate the CPI in 2005 and 2006. Calculate the inflation rate between 2005 and 2006 CPI in 2005: 45/80*100=56.25 CPI in 2006=100 Inflation rate=(100-56.25)/56.25*100%=77.8% (e) Explain whether there is any substitution bias in the CPI depending upon the choice of market basket and base year. The choice of base year does not affect the inflation rate. However, this example shows that the choice of market basket affects the inflation rate. This is because the inflation rate measures the change in prices of a bundle of goods. If we vary that bundle of goods, the increase in price will also change. In this example, using the 2005 production quantities as the market basket
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