Answers to Text Questions and Problems for Chapter 6
Answers to Review Questions
The CPI measures the cost of buying a particular “basket” of goods and services, relative to a
specified base year. The official basket of goods and services is intended to correspond to the buying
patterns of the typical family. However, a family whose buying patterns differ from the average may find
that changes in its cost of living are not well captured by the official CPI. For example, if the price of
peanut butter rises sharply, the cost of living of a family that buys much more peanut butter than the
typical family will increase more than the CPI, all else being equal.
The price level measures the cost of a basket of goods and services, relative to a base year. The CPI
is one standard measure of the price level. In contrast, the rate of inflation is the annual percentage change
in the price level. For example, suppose that the basket of goods and services on which the CPI is based
cost $100 in the base year, $150 last year, and $154.50 this year. The price level this year is 1.5450
($154.50/$100.00). The inflation rate from last year to this is the percentage increase in the cost of the
basket since last year, or 3%.
With inflation, increases in nominal quantities may simply reflect higher prices, rather than
increased production or purchasing power. For example, a 10% increase in a worker’s nominal wage
implies a 10% increase in purchasing power if prices are unchanged, but no increase in purchasing power
if prices have also risen by 10%. The basic method of adjusting for inflation, called deflating the nominal
quantity, is to divide by a price index, such as the CPI. For example, the real wage, equal to the nominal
wage divided by a price index, measures the purchasing power of the wage. Unlike nominal wages, real
wages at different points in time can be meaningfully compared.
In an indexed collective agreement, wages each year would automatically be increased at the rate of
inflation, preserving the purchasing power of the agreed-upon wage. For example, if prices of consumer
goods rise by 2% over the year (that is, the rate of inflation is 2%), an indexed wage will also
automatically rise by 2%, so that the quantity of goods the worker can purchase is unchanged.
The first two sentences are correct; the losses that unanticipated inflation imposes on creditors (for
example) are just offset by the gains to debtors. However, there is an overall cost to society when wealth
is redistributed arbitrarily. First, risk is increased, which makes people feel worse off. Second, when
wealth is determined more by random forces than by hard work and intelligent investment, the incentives
to engage in the latter are reduced, harming the efficiency of the economy. Finally, people use up
resources attempting to anticipate inflation and protect themselves against it; from society’s point of view,
these resources are wasted.