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Use of a fixed basket means that no allowance is made

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Use of a fixed basket means that no allowance is made for consumers’ substitution toward relatively less expensive goods. CPI tends to overstate the rate of inflation.
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39 Costs of Inflation Important to distinguish between relative price change and a change in the general price level Shoe-leather costs – inflation reduces the real purchasing power of a given amount of money Menu costs – real costs of changing prices Introduces noise into the price mechanism Distorts tax systems (if not indexed to inflation) Unexpected re-distributions of wealth
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40 Inflation and Interest Rates Nominal Interest Rates – percentage increase in the nominal (or dollar) value of a financial asset. Real Interest Rate – percentage increase in the real purchasing power of a financial asset. π = i r r = real interest rate i = nominal interest rate π = inflation rate
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41 Fisher Effect Nominal interest rate = real rate + (expected) inflation rate e r i π + =
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42 Inflation and Nominal Interest Rate -2.0 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 M ar-86 M ar-88 M ar-90 M ar-92 M ar-94 M ar-96 M ar-98 M ar-00 M ar-02 M ar-04 M ar-06 M ar-08 % per annum Inflation (year-ended) 10 Year Bond Rate
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