Econ 2006 Exam 2 Study Guide .docx - *ECON 2006 Exam 2...

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***ECON 2006 Exam 2 Study Guide*** Chapter 8: Price Level and Inflation Inflation: increase in overal l level of prices in an economy o Micro: looking at variables at an individual level o Macro: looking at variables at an aggregate level o Inflation rate = (CPI2-CPI1)/(CPI1)x100 - find CPI first o Causes: Expansion in nations Milton Friedman: Increase in nation’s money supply relative to quantity of real goods and services in an economy When supply of money in an economy grows relative to quantity of goods and services, then it takes more money to buy any particular good or service. Money becomes less valuable relative to goods and services o Substitution bias: evaluating the price of a basket of goods over time doesn’t account for changes that consumers make when the price of a particular good increases o Quality bias: failing to recognize the change in the quality of goods over time when accounting for inflation measures Deflation: when overall price level decreases o Not the price of a certain good going up due to a shift in demand or supply for a good o GDP deflator: better measure for how price changes affect overall economy o Decreases purchasing power Consumer Price Index (CPI): Measure of price level based on consumption pattern o Price index: it is a measure of how the prices included in the typical basket of goods have changed over time, holding the items in the consumption bundle constant o Includes: groceries, clothing, transportation, housing o Goal: include everything a typical consumer buys in order to get a realistic measure of the cost of living o Compute CPI: price index = (current period price of basket/base period price of basket) x 100 o Compute change in price: Price 2 –Price 1/Price 1 x 100 o Compare CPI over time calculation: Price today = price earlier x (price level today/price level earlier) o Note: some price changes affect us more than others o Prices included: Housing 41% Transportation 17% Food/Beverage 15% Medical Care 7%
Recreation 6% Communication 4% Apparel 4% Education 3% Other goods and services 3% o Concerns about CPI accuracy: Substitution When prices of a good rise, consumers look to subs as a cheaper alternative Causes a change in basket calculation Quality changes Quality of goods generally increase causing price to increase Ex: flat screen TVS New products and locations New products are introduced which leads to new buying options Ex: cell phones, tablets; not included in previous century baskets o The Cost of Inflation Workers: fear they’ll be underpaid Lenders: fear of lending money and getting less back Inflation is a tax on money so as inflation rises people try to get rid of money Cost of Inflation Description Shoe leather costs Time and resources are spent to guard against the effects of inflation Resources are wasted when people change behavior to avoid money holding Arise from additional transaction costs Money illusions

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