Mid2ReviewCh6-11and13withanswers - 1 ECN 211 Lecture Hall...

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ECN 211 Lecture Hall Class Review Sheet for Midterm 2 Spring Semester, 2011 (Revised 3/22/11) Chapters 6-11 and 13 (Note: Midterm 2 Excludes the Appendix to Chapter 10) 1. What is inflation? (Answer: Inflation is an increase in the average price level.) 2. What happens to relative prices as inflation occurs? (Answer: Relative prices change during the course of inflation because not all prices change by exactly the same percentage over time.) 3. How is inflation measured in the Consumer Price index? (Answer: Inflation is measured as a weighted average of the percentage changes in prices of a fixed basket of goods, where the weights are equal to the relative importance of the items in the typical consumer’s budget. Market Basket Quantities 1998 Price 1999 Price 5 X $2 $3 2 Y $15 $18 6 Z $10 $10 The fixed market basket costs $100 in 1998 and $111 in 1999. The ratio of $111 to $100 = 111/100 = 1.11 so the new value of the CPI is 111 if 1998 is the base year. To demonstrate that a price index is the weighted average of the percentage changes in prices we have the following: Percentage changes in prices (50% for A; 20% for B; 0% for C) and the following percentage of the budget spent on the three products as follows (A = 10%; B = 30%; C = 60%.) Weighting the percentages changes in prices by the percentage of the budget spent on each item we have: 50% * 10% + 20% * 30% + 0% * 60% = 5% + 6% = 11%. So if the price index read 100 in 1998, it will read 111 in 1999. 4. What is meant by the “base year” of a price index? (Answer: The base year value always is equal to 100.) 1
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5. How can the rate of inflation be measured between two years with the CPI? Suppose the CPI has a value of 120 in 1998 and 160 in 1999. (Answer: The rate of inflation between these two years is the change in the CPI (40) divided by the original value of the CPI (120). The rate is 40/120 = 33.3%. 6. What are the causes of inflation? (Answer: the basic causes of inflation are: (a) demand pull inflation; and (b) cost-push inflation. Demand pull inflation exists when the economy experiences too much demand for a full employment level of GDP. Cost push inflation occurs when changes in the costs of production or distribution cause the individual supply schedules of business firms to shift upward and to the left.) 7. Explain how inflation: (a) redistributes income and wealth: (b) affects investment expenditures in the economy; (c) affects nominal and real rates of interest. (Answer: A household’s real income is their nominal income divided by the consumer price index, with the result multiplied by 100. If the cost of living rises by 10% and family incomes rise by 10%, then real income is unchanged. Because each households nominal income does not necessarily rise by exactly the same percentage as the change in the cost of living, inflation redistributes GDP away from some households (whose nominal incomes do not keep up with changes in the cost of living) in favor of other households (whose nominal incomes more than keep up with
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This note was uploaded on 01/12/2012 for the course ECN 211 taught by Professor Kingston during the Spring '08 term at ASU.

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Mid2ReviewCh6-11and13withanswers - 1 ECN 211 Lecture Hall...

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