The CPI and the Cost of Living

Chapter

CHAPTER CHECKLIST Chapter 7 explores how the CPI and other price level indices are measured.

Explain what the Consumer Price Index (CPI) is and how it is calculated.

The Consumer Price Index (CPI) measures the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. The CPI compares the cost of the fixed market basket of goods and services at one time with the cost of the fixed market basket in the reference base period, currently 1982–1984. The CPI in the base period is 100. If the CPI is now 150, it costs 50 percent more to buy the same goods and services than it cost in the base period. To construct the CPI market basket, households are surveyed on what they buy. Then each month the Bureau of Labor Statistics checks the prices of the 80,000 goods and services in the basket. To calculate the CPI, the cost of the market basket using current prices is divided by the cost of the basket using base period prices and the result is multiplied by 100. The inflation rate is the percentage change in the price level from one year to the next and is equal to [(CPI in current year − CPI in previous year) ÷ (CPI in previous year)] × 100.

Explain the limitations of the CPI and describe other measures of the price level.

The CPI has four sources of bias that lead to an inaccurate measure of the cost of living. These biases are the new goods bias (new goods replace old goods), the quality change bias (goods and services increase in quality), the commodity substitution bias (changes in relative prices lead consumers to change the items they buy), and the outlet substitution bias (consumers switch to shopping more often in discount stores). The overall CPI bias has been estimated to overstate inflation by 1.1 percentage points per year. The CPI bias distorts private contracts, increases government outlays and decreases government tax revenues. The GDP price index is an average of current prices of all the goods and services included in GDP expressed as a percentage of base-year prices. The GDP price index uses the prices of all goods and services in GDP and weights each item using information about current quantities. The PCE (Personal Consumption Expenditure) price index is an average of the current prices of the goods and services included in the consumption expenditure component of GDP expressed as a percentage of base year prices. The core inflation rate is the percentage change in the PCE index excluding the prices of food and energy. The CPI inflation rate generally exceeds the PCE inflation rate.

Adjust money values for inflation and calculate real wage rates and real interest rates.

To compare values measured in dollars in different years, the nominal values must be converted to real values. Real GDP equals nominal GDP divided by the price level and multiplied by 100. The real wage rate measures the quantity of goods and services that an hour’s work can buy. It equals the nominal wage rate divided by the CPI and multiplied by 100. The real interest rate equals the nominal interest rate minus the inflation rate. © 2013 Pearson Education, Inc. Publishing as Addison Wesley

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CHECKPOINT 7.1  Explain what the Consumer Price Index (CPI) is and how it is calculated. Quick Review • CPI market basket The goods and services in the CPI and the relative importance attached to each of them. • CPI formula The CPI equals: Cost of CPI basket at current period prices × 100. Cost of CPI basket at base period prices •

Inflation rate The inflation rate equals:

(CPI in current year − CPI in previous year) CPI in previous year

× 100.

Additional Practice Problem 7.1 Item Limes Biscuits Rum

Quantity (2011) 20 30 10

Price (2011) $1.00 $1.00 $10.00

Quantity (2012) 15 45 8

Price (2012) $1.00 $0.75 $11.00

1. A Consumer Expenditure Survey in Scurvy shows that people consume only limes, biscuits, and rum. The Consumer Expenditure Survey for both 2011 and 2012 are in the table above. The base year is 2011. a. What and how much is in the CPI market basket? b. What did the CPI market basket cost in 2011? What was the CPI in 2011? c. What did the CPI market basket cost in 2012? What was the CPI in 2012? d. What was the inflation rate between 2011 and 2012? Solution to Additional Practice Problem 7.1 1a. The market basket is 20 limes, 30 biscuits, and 10 rums, the quantities consumed in the base year of 2011. 1b. In 2011 the market basket cost (20 × $1.00) + (30 × $1.00) + (10 × $10.00) = $150. Because 2009 is the base year, the CPI = 100.0.

1c. In 2012 the market basket cost (20 × $1.00) + (30 × $0.75) + (10 × $11.00) = $152.50. The CPI in 2012 is equal to ($152.50) ÷ ($150.00) × 100, which is 101.7. 1d. The inflation rate equals [(101.7 − 100.0) ÷ 100] × 100 = 1.7 percent.

 Self Test 7.1 Fill in the blanks The ____, also called the CPI, is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. In the reference base period, the CPI equals ____. Each ____ (month; year) the Bureau of Labor Statistics checks the prices of the goods and services in the CPI basket. The CPI equals the cost of the CPI basket at current prices ____ (plus; minus; divided by) the cost of the CPI basket at base period prices, all multiplied by 100. To measure changes in the cost of living, the ____ (inflation rate; CPI in the reference base period) is used. True or false 1. In the reference base period, the CPI equals 1.0. 2. The CPI market basket is changed from one month to the next. 3. If the cost of the CPI basket at current period prices equals $320, then the CPI equals 320. 4. If the cost of the CPI market basket at current period prices exceeds the cost of the CPI market basket at base period prices, the inflation rate between these two periods is positive. 5. If the CPI increases from 110 to 121, the inflation rate is 11 percent. Multiple choice 1. The CPI is reported once every a. year. b. quarter. c. month. d. week. e. other year.

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Chapter 7 . The CPI and the Cost of Living

2. The Consumer Price Index (CPI) measures a. the prices of a few consumer goods and services. b. the prices of those consumer goods and services that increased in price. c. the average of the prices paid by urban consumers for a fixed market basket of goods and services. d. consumer confidence in the economy. e. the average of the costs paid by businesses to produce a fixed market basket of consumer goods and services. 3. If a country had a CPI of 105.0 last year and a CPI of 102.0 this year, then a. the average prices of goods and services increased between last year and this year. b. the average prices of goods and services decreased between last year and this year. c. the average quality of goods and services decreased between last year and this year. d. there was an error when calculating the CPI this year. e. the quantity of consumer goods and services produced decreased between last year and this year. 4. The period for which the Consumer Price Index is defined to equal 100 is called the a. reference base period. b. base year. c. starting point. d. zero period. e. beginning period. 5. In the United States, the good or service given the most weight in the CPI basket when calculating the CPI is a. food and beverages. b. taxes. c. housing. d. medical care. e. recreation. 6. Suppose the market basket of consumer goods and services costs $180 using the base period prices, and the same market basket of goods and services costs $300 using the cur-

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rent period prices. The CPI for the current period equals a. 166.7. b. 66.7. c. 160.0. d. 60.0. e. 300.0. 7. Suppose the CPI last year was 82.3 and this year is 90.9. Based on this information, we can calculate that the inflation rate between these years is a. 10.4 percent. b. 8.6 percent. c. 90.9 percent. d. 82.3 percent. e. 9.09 percent. 8. In the United States, the inflation rate since 1999 generally was a. higher than between 1979 to 1981. b. much higher than in the 1980s. c. lower than between 1979 to 1981. d. much higher than between 1989 to 1999. e. negative. Short answer and numeric questions Item Pizza Burritos Rice

Quantity (2011) 10 20 30

Price (2011) $10.00 $1.00 $0.50

Quantity (2012) 15 25 20

Price (2012) $10.00 $0.75 $1.00

1. The table above gives the expenditures of households in the small nation of Studenvia. 2011 is the reference base period. a. What is the cost of the CPI market basket in 2011? b. What is the cost of the CPI market basket in 2012? c. What is the CPI in 2011? d. What is the CPI in 2012? e. What is the inflation rate in 2012? 2. Suppose the CPI was 100.0 in 2011, 110.0 in 2012, 121.0 in 2013, and 133.1 in 2014. What is the inflation rate in 2012, 2013, and 2014? 3. If the price level rises slowly, is the inflation rate positive or negative? Why?

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Additional Exercises (also in MyEconLab Test A) The people of Firestorm City buy only firecrackers and bandages. A Consumer Expenditure Survey in 2011 shows that the average household spent $150 on firecrackers and $15 on bandages. In 2007, the reference base year, the price of a firecracker was $2, and the price of bandages was $1 a pack. In the current year, 2012, firecrackers are $3 each and bandages are $1.25 a pack. 1. Calculate the CPI market basket and the percentage of a household’s budget spent on firecrackers in the base year. 2. Calculate the CPI in 2012 and the inflation rate in 2012.

CHECKPOINT 7.2  Explain the limitations of the CPI and describe other measures of the price level. Quick Review • Commodity substitution bias People cut back on their purchases of items that become relatively more costly and increase their consumption of items that become relatively less costly. Additional Practice Problems 7.2 1. When households buy broccoli, they discard some of it because it is bruised. Say 20 percent is discarded. Now suppose that new, genetically engineered broccoli is developed that does not bruise so that all the broccoli that is purchased can be used. People prefer the new broccoli, so they switch to buying the new broccoli. If the price of the new broccoli is 10 percent higher than the old, what actually happens to the CPI and what should happen to the CPI? 2. When the price of textbook is $105 a book, Anthony buys his books at the bookstore closest to him. When textbooks rise in price to $145 a book at that store, Anthony drives several miles away to a store where the books are sold

for only $125. How does Anthony’s decision affect the CPI? Solutions to Additional Practice Problems 7.2 1. With the introduction of the new broccoli, the CPI rises because the new broccoli’s price is higher (10 percent) than the old broccoli. But, the CPI should actually decrease because people pay only 10 percent more for 20 percent more (useable) broccoli. This problem illustrates how the quality change bias can bias the CPI upwards. 2. Anthony’s decision reflects outlet substitution. When the price of a good rises, consumers, such as Anthony, switch the stores from which they buy goods and services to less expensive outlets. But the CPI, as constructed, does not take into account this point. The CPI will record that the price of textbooks rose by $40, from $105 to $145. This outlet substitution bias means that the CPI overstates the true rise in the cost of living.

 Self Test 7.2 Fill in the blanks The sources of bias in the CPI as a measure of the cost of living are the ____, ____, ____, and ____. The Boskin Commission concluded that the CPI ____ (overstates; understates) inflation by ____ (1.1; 2.2; 3.3) percentage points a year. The CPI bias leads to ____ (an increase; a decrease) in government outlays. True or false 1. The CPI is a biased measure of the cost of living. 2. Commodity substitution bias refers to the ongoing replacement of old goods by new goods. 3. The bias in the CPI is estimated to overstate inflation by approximately 1.1 percentage points a year. 4. The CPI bias can distort private contracts. 5. The GDP price index is influenced by the prices of investment goods as well as the prices of exported goods and services.

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Chapter 7 . The CPI and the Cost of Living

6. The core inflation rate is the inflation rate of energy and food prices. 7. Inflation measured using the GDP price index is generally lower than inflation measured using the CPI. Multiple choice 1. All of the following are a bias in the CPI EXCEPT the a. new goods bias. b. outlet substitution bias. c. commodity substitution bias. d. GDP price index bias. e. quality change bias. 2. An example of the new goods bias in the calculation of the CPI is a price increase in a. butter relative to margarine. b. an iPod player relative to a Walkman. c. a 2012 Honda Civic Si Coupe relative to a 2012 Honda Civic Si Sedan. d. textbooks bought through the campus bookstore relative to textbooks bought through Amazon.com. e. a Caribbean cruise for a couple who has never been on a cruise before. 3. The price of dishwashers has remained constant while the quality of dishwashers has improved. The CPI a. is adjusted monthly to reflect the improvement in quality. b. is increased monthly to reflect the increased quality of dishwashers. c. has an upward bias if it is not adjusted to take account of the higher quality. d. has an upward bias because it does not reflect the increased production of dishwashers. e. does not take account of any quality changes because it is a price index not a quality index.

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4. Joe buys chicken and beef. If the price of beef rises and the price of chicken does not change, Joe will buy ____ for the CPI. a. more beef and create a new goods bias b. more chicken and create a commodity substitution bias c. the same quantity of beef and chicken and create a commodity substitution bias d. less chicken and beef and create a quality change bias e. more chicken and eliminate the commodity substitution bias 5. The CPI bias was estimated by the Congressional Advisory Commission on the Consumer Price Index as a. understating the actual inflation rate by about 5 percentage points a year. b. understating the actual inflation rate by more than 5 percentage points a year. c. overstating the actual inflation rate by about 1 percentage point a year. d. overstating the actual inflation rate by more than 5 percentage points a year. e. understating the actual inflation rate by about 1 percentage point a year. 6. A consequence of the CPI bias is that it a. decreases government outlays. b. increases international trade. c. reduces outlet substitution bias. d. distorts private contracts. e. means that it is impossible to measure the inflation rate.

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7. Because the CPI is a biased measure of the inflation rate, government outlays will a. increase at a faster rate than the actual inflation rate. b. increase at the same rate as the actual inflation rate. c. increase at a slower rate than the actual inflation rate. d. sometimes increase faster and sometimes increase slower than the actual inflation rate depending on whether the actual inflation rate exceeds 1.1 percent per year or is less than 1.1 percent per year. e. None of the above because the bias in the CPI does not affect government outlays. Short answer and numeric questions 1. What are the sources of bias in the CPI? Briefly explain each. 2. Once you graduate, you move to a new town and sign a long-term lease on a townhouse. You agree to pay $1,000 a month rent and to change the monthly rent annually by the percentage change in the CPI. For the next 4 years, the CPI increases 5 percent each year. What will you pay in monthly rent for the second, third, and fourth years of your lease? Suppose the CPI overstates the inflation rate by 1 percentage point a year. If the CPI bias was eliminated, what would you pay in rent for the second, third, and fourth years? 3. How is the core inflation rate calculated? Additional Exercises (also in MyEconLab Test A) 3005

3006

Item

Quantity

Price

Quantity

Games

20

$60

10

$70

Time travel

0

--

20

$8,000

Price

1. In Virtual Reality, time travel became possible only in 3006. Economists in the Statistics Bureau decided to conduct a Consumer Expenditure Survey in both 3005 and 3006 to check the substitution bias of the CPI. The table shows the results of the survey. It shows the items that consumers buy and

their prices. The Statistics Bureau fixes the reference base year as 3005. Calculate the CPI in 3006 and the inflation rate measured by the CPI in 3006.

CHECKPOINT 7.3  Adjust money values for inflation and calculate real wage rates and real interest rates. Quick Review • Real wage rate The real wage rate equals the nominal wage rate divided by the CPI and multiplied by 100. • Real interest rate The real interest rate equals the nominal interest rate minus the inflation rate. Additional Practice Problems 7.3 Year 1955 1965 1975 1985 1995 2005

Minimum wage (dollars per hour) 0.75 1.25 2.10 3.35 4.25 5.15

CPI 26.7 31.6 56.7 107.5 152.4 194.1

1. The table above shows the minimum wage and the CPI for six different years. The reference base period is 1982–1984. a. Calculate the real minimum wage in each year in 1982–1984 dollars. b. In which year was the minimum wage the highest in real terms? c. In which year was the minimum wage the lowest in real terms? 2. Nominal GDP = $10 trillion, real GDP = $9 trillion. What is the GDP price index? 3. Suppose Sally has saved $1,000 dollars. Sally wants a 3 percent real interest rate on her savings. What nominal interest rate would she need to receive if the inflation rate is 7 percent?

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Chapter 7 . The CPI and the Cost of Living

Solutions to Additional Practice Problems 7.3

Year 1955 1965 1975 1985 1995 2005

Real minimum wage (1982-1984 dollars per hour) 2.81 3.96 3.70 3.12 2.79 2.65

1a. Using the CPI to adjust nominal values to real values is a key use of the CPI. Keep in mind that to convert a nominal price (such as the nominal wage rate) into a real price (such as the real wage rate), you divide by the CPI and multiply by 100, but to convert the nominal interest rate into the real interest rate, you subtract the inflation rate. To convert the nominal minimum wages in the table to real prices, divide the price by the CPI in that year and then multiply by 100. In 1955, the nominal minimum wage gas was $0.75 an hour and the CPI was 26.7, so the real minimum wage is ($0.75 ÷ 26.7) × 100 = $2.81. The rest of the real minimum wages in the table above are calculated similarly. 1b. In real terms, the minimum wage was highest in 1965 when it equaled $3.96. 1c. In real terms, the minimum wage was the lowest in 2005 when it equaled $2.65. 2. GDP price index = (Nominal GDP ÷ Real GDP) × 100 = ($10 trillion ÷ $9 trillion) × 100 = 111.1. 3. The real interest rate equals the nominal interest rate minus the inflation rate. Rearranging this formula shows that the nominal interest rate equals the real interest rate plus the inflation rate. To get a 3 percent real interest rate with a 7 percent inflation rate, Sally needs the nominal interest rate to be equal to 3 percent plus 7 percent, or 10 percent.

 Self Test 7.3 Fill in the blanks The GDP price index equals 100 times ____ (real nominal) GDP divided by ____ (real; nominal) GDP. The nominal wage rate is the average

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hourly wage rate measured in ____ (current; reference base year) dollars. The real wage rate is the average hourly wage rate measured in dollars of the ____ (current; given base) year. The real wage rate equals the nominal wage rate ____ (plus; times; divided by) the CPI multiplied by 100. The real interest rate equals the nominal interest rate ____ (plus; minus; divided by) the ____ (CPI; inflation rate). True or false 1. Real prices and nominal prices are unrelated. 2. Real GDP equals nominal GDP divided by the CPI, multiplied by 100. 3. A change in the real wage rate measures the change in the goods and services that an hour’s work can buy. 4. The nominal interest rate is the percentage return on a loan expressed in dollars; the real interest rate is the percentage return on a loan expressed in purchasing power. 5. If the nominal interest rate is 8 percent a year and the inflation rate is 5 percent a year, then the real interest rate is 3 percent a year. Multiple choice 1. In 2011 apples cost $1.49 a pound. The CPI was 120 in 2011 and 140 in 2012. If there is no change in the real price of an apple in 2012, what is the price of a pound of apples in 2012? a. $2.74 b. $1.69 c. $1.66 d. $1.74 e. $1.28 2. In 1970, the CPI was 39 and in 2000 it was 172. A local phone call cost $0.10 in 1970. What is the price of this phone call in 2000 dollars? a. $1.42 b. $0.39 c. $1.72 d. $0.44 e. $0.23

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3. Nominal GDP is $12.1 trillion and real GDP is $11.0 trillion. The GDP price index is a. 90.1. b. 121.0 c. 1.10. d. 91.0. e. 110.0 4. The nominal wage rate is the a. minimum hourly wage that a company can legally pay a worker. b. average hourly wage rate measured in the dollars of a given base year. c. minimum hourly wage rate measured in the dollars of a given reference base year. d. average hourly wage rate measured in current dollars. e. wage rate after inflation has been adjusted out of it. 5. The average starting salary for a history major is $29,500. If the CPI is 147.5, the real salary is a. $200.00 an hour. b. $20,000. c. $35,000. d. $43,513. e. $14,750. 6. Since 1981, the a. real wage rate increased steadily. b. nominal wage rate increased and the real wage rate did not change by very much. c. real wage rate increased more than the nominal wage rate. d. nominal wage rate increased at an uneven pace whereas the increase in the real wage rate was steady and constant. e. nominal wage rate and real wage rate both decreased. 7. The real interest rate is equal to the a. nominal interest rate plus the inflation rate. b. nominal interest rate minus the inflation rate. c. nominal interest rate times the inflation rate. d. nominal interest rate divided by the inflation rate. e. inflation rate minus the nominal interest rate.

8. You borrow at a nominal interest rate of 10 percent. If the inflation rate is 4 percent, then the real interest rate is a. the $10 in interest you have to pay. b. 16 percent. c. 2.5 percent. d. 6 percent. e. 14 percent. 9. In the United States for the last 40 years, the nominal interest rate a. and the real interest rate both decreased in almost every year. b. and the real interest rate were both constant in almost every year. c. was constant in most years and the real interest rate fluctuated. d. exceeded the real interest rate in virtually all the years. e. exceeded the real interest rate in about half of the years and the real interest rate was greater than the nominal interest rate in the other half of the years. Short answer and numeric questions 1. For each of the following pairs of real GDP and nominal GDP, calculate the price level. a. Nominal GDP = $12 trillion, real GDP = $10 trillion. b. Nominal GDP = $12 trillion, real GDP $16 trillion. c. Nominal GDP = $8 trillion, real GDP = $4 trillion.

Job Job A Job B Job C

Salary (dollars per year) 20,000 25,000 34,000

CPI 105 120 170

2. Often the cost of living varies from state to state or from large city to small city. After you graduate, suppose you have job offers in 3 locales. The nominal salary and the CPI for each job is given in the table above. a. Which job offers the highest real salary? b. Which job offers the lowest real salary?

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Chapter 7 . The CPI and the Cost of Living

c. In determining which job to accept, what is more important: the real salary or the nominal salary? Why?

Year 2010 2011 2012 2013

Real Nominal Inflation interest rate interest rate rate (percent (percent (percent per year) per year) per year) ____ 10 5 ____ 6 1 ____ 4 6 5 ____ 3

3. The table above gives the real interest rate, nominal interest rate, and inflation rate for various years in a foreign country. Complete the table. 4. In 1980, the nominal interest rate was 12 percent. In 2011, the nominal interest rate was 4 percent. From this information, can you determine if you would rather have saved $1,000 in 1980 or 2011? Explain your answer.

Year 1992 1993 1994 1995 1996

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Nominal Inflation interest rate rate (percent per year) 4.6 1.7 3.0 1.2 2.1 0.7 1.2 −0.1 0.4 0.1

2. The table shows the nominal interest rate and inflation rate in Japan for several years. In which year was the real interest rate the highest and in which year was the real interest rate the lowest? 3. In 1986, 1996, and 2006, average weekly earnings in the United States were $310, $413, and $567 respectively. The CPI was 110, 157, and 202 respectively. In which of these three years was the real average weekly earnings highest and in which year was it lowest?

Additional Exercises (also in MyEconLab Test A) 1. In 2005, the GDP price index was 105 and real GDP was $4 trillion (2000 dollars). In 2006, nominal GDP was $5.4 trillion and real GDP was $4.5 trillion (2000 dollars). Calculate the increase in nominal GDP and the increase in the GDP price index in 2006.

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SELF TEST ANSWERS  CHECKPOINT 7.1 Fill in the blanks The Consumer Price Index, also called the CPI, is a measure of the average of the prices paid by urban consumers for a fixed market basket of consumer goods and services. In the reference base period, the CPI equals 100. Each month the Bureau of Labor Statistics checks the prices of the goods and services in the CPI basket. The CPI equals the cost of the CPI basket at current prices divided by the cost of the CPI basket at base period prices, all multiplied by 100. To measure changes in the cost of living, the inflation rate is used. True or false 1. False; page 164 2. False; page 164 3. False; page 167 4. True; page 167 5. False; page 167 Multiple choice 1. c; page 164 2. c; page 164 3. b; page 164 4. a; page 164 5. c; page 165 6. a; page 167 7. a; page 167 8. c; page 168 Short answer and numeric questions 1. a. The cost is $135; page 166. b. The cost is $145. The quantities used to calculate this cost are the base period, 2009, quantities; page 166. c. The CPI is 100; page 167. d. The CPI is 107.4; page 167. e. The inflation rate is 7.4 percent; page 167. 2. The inflation rate for each year is 10 percent; page 167. 3. Whenever the price level rises, the infla-

tion rate is positive. If the price level rises slowly, the inflation rate is small; if the price level rises rapidly, the inflation rate is large; page 167. Additional Exercises (also in MyEconLab Test A) 1. The CPI market basket is the quantities bought during the Expenditure Survey year, 2011. Households spend $150 on firecrackers at $2 a firecracker so the quantity of firecrackers bought was 75. Households spend $15 on bandages at $1 a pack so the quantity of bandages bought was 15 packs. The CPI market basket is 75 firecrackers and 15 packs of bandages. In the base year, expenditure on firecrackers was $150 and expenditure on bandages was $15, so the household budget was $165. Expenditure on firecrackers was ($150 ÷ $165) × 100, which is 90.9 percent of the household budget; pages 166-167. 2. To calculate the CPI in 2012, find the cost of the CPI market basket in 2012 and 2011. In 2011, the CPI market basket costs $165 ($150 for firecrackers and $15 for bandages). In 2012, the CPI basket costs $225 for firecrackers (75 × $3 a firecracker) plus $18.75 (15 packs of bandages × $1.25 a pack), which sums to $243.75. The CPI in 2012 equals ($243.75 ÷ $165) × 100 = 147.7. The inflation rate in 2012 is [(147.7 − 100.0) ÷ 100.0] × 100, which is 47.7 percent; pages 166-167.

 CHECKPOINT 7.2 Fill in the blanks The sources of bias in the CPI as a measure of the cost of living are the new goods bias, quality change bias, commodity substitution bias, and outlet substitution bias. The Boskin Commission concluded that the CPI overstates inflation by 1.1 percentage points a year. The CPI bias leads to an increase in government outlays.

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Chapter 7 . The CPI and the Cost of Living

True or false 11. True; 12. False; 13. True; 14. True; 15. True; 16. False; 17. True;

page 170 page 171 page 171 page 172 page 173 page 173 page 174

Multiple choice 11. d; page 170 12. b; page 170 13. c; page 171 14. b; page 171 15. c; page 171 16. d; page 172 17. a; page 172 Short answer and numeric questions 1. There are four sources of bias in the CPI: the new goods bias, the quality change bias, the commodity substitution bias, and the outlet substitution bias. The new goods bias refers to the fact that new goods replace old goods. The quality change bias occurs because at times price increases in existing goods are the result of increased quality. The commodity substitution bias occurs because consumers buy fewer goods and services when their prices rise compared to other, comparable products. Finally, the outlet substitution bias refers to the fact that when prices rise, people shop more frequently at discount stores to take advantage of the lower prices in these stores; pages 170-171. 2. The monthly rent increases by 5 percent each year. For the second year the monthly rent equals $1,000 × 1.05, which is $1,050. For the third year the monthly rent equals $1,050 × 1.05, which is $1,102.50. And for the fourth year the monthly rent equals $1,102.50 × 1.05, which is $1,157.63. If the CPI bias was eliminated, the monthly rent would increase by 4 percent each year. The monthly rent would be $1,040

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for the second year, $1,081.60 for the third year, and $1,124.86 for the third year; page 172. 3. The core inflation rate is the inflation rate calculated using the PCE price level excluding the prices of energy and food; page 173. Additional Exercises (also in MyEconLab Test A) 1. Using the 3005 CPI market basket, the cost of the basket in 3005 is $1,200 and the cost of the basket in 3006 is $1,400. (Note that time travel does not enter into the cost in 3006 because it is not in the CPI market basket.) So the CPI in 3006 is ($1,400 ÷ $1,200) × 100, which is 116.7. The change in the CPI from 3005 to 3006 is 16.7. The initial CPI in 3005 is 100.0 (since it is a base year). So the inflation rate is equal to (16.7 ÷ 100) × 100, or 16.7 percent; pages 166-167, 170.

 CHECKPOINT 7.3 Fill in the blanks The GDP price index equals 100 times nominal GDP divided by real GDP. The nominal wage rate is the average hourly wage rate measured in current dollars. The real wage rate is the average wage rate measured in dollars of the given base year. The real wage rate equals the nominal wage rate divided by the CPI multiplied by 100. The real interest rate equals the nominal interest rate minus the inflation rate. True or false 1. False; page 176 2. False; page 178 3. True; pages 178-179 4. True; page 180 5. True; page 180 Multiple choice 1. d; page 176 2. d; page 176 3. e; page 178 4. d; page 178

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5. 6. 7. 8. 9.

b; b; b; d; d;

page 178 pages 178-179 page 180 page 180 page 181

Short answer and numeric questions 1. a. GDP price index = ($12 trillion ÷ $10 trillion) × 100 = 120; page 178. b. GDP price index = ($12 trillion ÷ $16 trillion) × 100 = 75; page 178. c. GDP price index = ($8 trillion ÷ $4 trillion) × 100 = 200; page 178. 2. a. The real salary equals (nominal salary ÷ CPI) × 100. The real salary is $19,048 for Job A, $20,833 for Job B, and $20,000 for Job C. The real salary is highest for Job B; page 178. b. The real salary is lowest for Job A; page 178. c. The real salary is more important than the nominal salary because the real salary measures the quantity of goods and services you can buy; pages 178-179.

Year 2010 2011 2012 2013

Real Nominal Inflation interest rate interest rate rate (percent (percent (percent per year) per year) per year) 5 10 5 5 6 1 4 6 2 5 8 3

3. The completed table is above; page 176. 4. You cannot determine when you would rather have been a saver. Savers are interested in the real interest rate because the real interest rate is the percentage return expressed in purchasing power. Without knowing the inflation rate, there are not enough data given to compute the real interest rate; page 180.

Additional Exercises (also in MyEconLab Test A) 1. Nominal GDP = real GDP × P ÷ 100, where P is the GDP price index. So in 2005 nominal GDP equals $4 trillion × 105 ÷ 100, which is $4.2 trillion. Between 2005 and 2006, nominal GDP has increased by $1.2 trillion, which is 28.6 percent. The equality Nominal GDP = real GDP × P ÷ 100 can be rearranged to give P = nominal GDP ÷ real GDP × 100. So in 2006, the GDP price index equals $5.4 trillion ÷ $4.5 trillion × 100, which is 120. Between 2005 and 2006, the GDP price index has increased by 15, which is 14.3 percent; pages 177-178. 2. The real interest rate for each year is equal to the nominal interest rate minus the inflation rate. Using this formula yields: 1992 4.6 percent − 1.7 percent = 2.9 percent 1993 3.0 percent − 1.2 percent = 1.8 percent 1994 2.1 percent − 0.7 percent = 1.4 percent 1995 1.2 percent − (−0.1) percent = 1.3 percent 1996 0.4 percent − 0.1 percent = 0.3 percent The real interest rate was the highest in 1992 and lowest in 1996; page 180. 3. The real wage rate is equal to the nominal wage rate divided by the CPI and then multiplied by 100. So the 1986 real wage rate equals $310 ÷ 110 × 100, or $281.82. The 1996 real wage rate equals $413 ÷ 157 × 100, or $263.06. And the 2006 real wage rate equals $567 ÷ 202 × 100, or $280.69. The real wage rate was the highest in 1986 and was the lowest in 1996; page 178.

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