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1 Page 1 of When there is no deflation or inflation, Prices of all goods change by the same percentage. Relative prices remain unchanged. Average prices do not change. Full employment is achieved. Some prices may rise or fall, but on average prices are constant.

2 Page 2 of During the time period represented in Figure 7.1, Country A Experienced periods of both inflation and deflation. Never achieved the inflation goal set by the Full Employment and Balanced Growth Act of Had no need for COLAs. Experienced only inflation. Since the CPI remained constant, the cost of living also remained constant; therefore there was no need for COLAs.

3 Page 3 of The redistributive mechanics of inflation include all of the following except Price effects. Income effects. Wealth effects. Output effects. Redistribution occurs because different people buy and sell different goods and own different assets. 4. Which of the following is not true about your nominal income? It is the amount of money you receive during a given time period. It is measured in current dollars. It is not an accurate measure of purchasing power. It is the same as your real income in times of high inflation. Real income is a measure of the quantity of goods and services your dollars will buy, and your nominal income is the amount of money you receive in a particular time period. 5. The amount of money income received in a given time period, measured in current dollars, is Nominal income. Real income. Relative income. The Consumer Price Index. Nominal income is based in today's dollars but is less helpful in determining the actual amount of goods and services it can purchase.

4 Page 4 of Real income is Nominal income adjusted for inflation. The amount of money income received in a given time period, measured in current dollars. The use of nominal dollars to gauge changes in income. None of the other choices. Real income takes into account changes to the price level, so it is a much better guide to how much your income will purchase in goods and services. 7. If deflation is 0.5 percent per year and you receive a 1 percent decrease in your salary, then your Real income falls, but your nominal income remains unchanged. Real and nominal income both fall. Real income remains unchanged, but your nominal income rises. Real and nominal income both rise. In this case, your nominal income has fallen faster than the price level has fallen, leading you to have less real income as well. Difficulty: 3 Hard 8. During a period of unanticipated inflation, Debtors are better off and creditors are worse off. Debtors and creditors are both better off because of lower real interest rates. Individuals on fixed incomes are better off. All individuals are worse off because of the level of uncertainty. If neither party anticipates inflation, then borrowers win because they repay lenders with money that is less valuable than what they borrowed.

5 Page 5 of According to Figure 7.3, prices and wages were rising, so Sellers of output were better off than wage earners. Everyone must have been worse off since the price level rose faster than incomes. There were no redistributive effects of inflation. The economy was experiencing stagflation. Since prices were rising faster than wages, the sellers of final output were gaining at the expense of the workers that made the product or service that was sold. Difficulty: 3 Hard

6 Page 6 of A friend tells you that his income has risen every year by 5 percent. At the same time, prices, on average, have risen by 5 percent. Your friend claims he is better off. Your friend Is experiencing money illusion. Really is better off as he suggests. Has experienced an increase in nominal and real income. Has experienced an increase in real income only. Since your friend is using only nominal income to determine if he's better off and his real income is remaining constant, he is experiencing money illusion. 11. All of the following are macroeconomic effects of inflation except Uncertainty. Speculation. Bracket creep. Lower taxes. Taxes will typically rise with inflation due to bracket creep unless the brackets are adjusted for inflation. 12. The movement of taxpayers into higher tax brackets as nominal incomes grow is Bracket leap. Bracket hike. Bracket creep. Inflation hike. Unless the tax brackets are adjusted for inflation, bracket creep will impact many taxpayers whose real income has not increased. If percentage increases of wages are equal to percentage increases in prices, then the before-tax real income will be unchanged. However, with inflation moving the worker into a higher tax bracket, the after-tax real income will fall.

7 Page 7 of If the price level is falling, all of the following are true except Lenders are better off. Businesses are reluctant to borrow money. Purchasing power increases. Borrowers are not affected. Borrowers are affected in that the debts they must repay are paid back with dollars worth more than what they borrowed. 14. During a period of deflation, Time horizons are longer. Consumer confidence increases. Lenders are better off. Borrowers are better off. Lenders gain during deflationary periods because they are repaid in dollars worth more than the ones they lent out. 15. The Consumer Price Index is A measure of changes in the average price of all goods and services. A measure of changes in the average price of consumer goods and services. Used to measure the impact of business speculation on consumers. The impact felt by consumers who move into a higher tax bracket because of inflation. The CPI takes into account the weight and importance of items purchased by consumers and uses these data as a measure of inflation.

8 Page 8 of The inflation rate is the Monthly percentage rate increase in the price of all goods and services. Annual percentage rate increase in tax brackets. Annual percentage rate increase in the average price level. Monthly adjustment of wages to the cost of living. The percentage increase in the average price level from year to year is known as inflation. 17. At the beginning of 2000, the CPI was At the beginning of 2001, it was What was the approximate rate of inflation in 2000? 7.6 percent percent percent percent. The percentage change in the price level from one year to the next is the difference in the CPI divided by the value in the first year. In this case, {( ) 159.3} 100 = 11.5 percent. 18. The Producer Price Index (PPI) is the best index to measure average price changes faced by Consumers. Producers. Importers. Labor unions negotiating COLAs. The PPI measures changes to the prices of things purchased by businesses.

9 Page 9 of At the beginning of 1989, the GDP deflator was At the end of 2004, it was What was the total percentage change in prices over this 15-year period? 98.9 percent percent percent percent. The percentage change in the GDP deflator is equal to the difference in the values divided by the initial value. The percentage change in the price level from one year to the next is the difference in the GDP deflator divided by the value in the first year. In this case, ( ) 93.6 = or percent. For further analysis, this does not measure the inflation rate, which is an annual concept. However, it can be done on an annualized compound rate if one takes the number of years or 15 th root of (new/old) or 15 th root of (189.2/93.6). The 15 th root is ; then subtract 1, which would give it the annualized inflation rate of 4.80 percent. Difficulty: 3 Hard 20. If nominal GDP is constant, then the GDP deflator varies inversely with The unemployment rate. Real GDP. COLAs. The CPI. If the GDP deflator rises while nominal GDP is constant, real GDP must be lower; this is due to the fact that prices are higher, so the actual production must be lower.

10 Page 10 of Based on Table 7.1, the rate of inflation between 2003 and 2004, using the GDP deflator, was 2.4 percent. 2.9 percent. 6.2 percent. 4.1 percent. The inflation rate is equal to the difference in the price index divided by the GDP deflator in 2003.

11 Page 11 of Based on Table 7.2, the rate of inflation between 2001 and 2002 using the CPI was 2.65 percent percent percent percent. The inflation rate can be calculated by taking the difference in the CPI values and dividing the result by the value of the CPI in 2001.

12 Page 12 of Based on Table 7.2, the real GDP for 2002 was $7,749.0 billion. $4,783.6 billion. $5,122.0 billion. $8,297.1 billion. The real GDP can be determined by dividing the nominal GDP by the GDP deflator and then multiplying the result by Price stability Is defined as a 0 percent rate of inflation in the Full Employment and Balanced Growth Act of Is targeted at a 3 percent rate of inflation by Alan Greenspan, the head of the Federal Reserve. Has been officially set by Congress at 3 percent or less. Has been achieved consistently in the 20 th century in the United States. It is important to maintain price stability so that price changes do not cause instability and speculation. Learning Objective: The meaning of price stability.

13 Page 13 of If the CPI doesn't measure product quality improvements, the CPI tends to Understate the inflation rate. Overstate the inflation rate. Understate economic growth. Be artificially low. If the CPI registers a price increase that is due to quality improvements, unfortunately that is mistaken for inflation; but in fact consumers are paying more to get more. Learning Objective: The meaning of price stability. 26. All of the following statements about inflation in the United States are correct except Since the Great Depression, average prices have risen almost every year. The inflation rate was 13.5 percent in Prior to World War II, the United States experienced periods of both deflation and inflation. Inflation was at its worst during the Great Depression. During the Great Depression, deflation was actually a significant concern. 27. If consumers attempt to buy more goods than the economy can produce, the result is Unemployment. Demand-pull inflation. Cost-push inflation. The wealth effect. When excess demand causes the price level to rise, the result is demand-pull inflation because it is the increase in demand that is causing prices to rise.

14 Page 14 of If the economy is producing at capacity and consumers are willing and able to buy more, this may cause Demand-pull inflation. Cost-push inflation. Supply-side inflation. The price effect. Excess demand that results in an increasing price level is known as demand-pull inflation. 29. When natural disasters, such as hurricanes on the U.S. Gulf Coast or an earthquake in Japan, disrupt supply chains and push up the costs of production, this may result in Labor-push inflation. Demand-pull inflation. Wage-pull inflation. Cost-push inflation. Inflation that results from higher production costs in known as cost-push inflation. 30. A COLA is A mortgage that adjusts the nominal interest rate to changing rates of inflation. A price index that refers to all goods and services included in GDP. An automatic adjustment of nominal income to the rate of inflation. An inflation rate of at least 200 percent, lasting more than one year. To maintain constant real income, COLAs (cost-of-living adjustments) can be used to keep nominal income rising at the same rate as the price level.

15 Page 15 of Cost-of-living adjustments Reduce the price effect of inflation. Allow individuals to maintain their purchasing power during inflation. Cause individuals to shorten their time horizons. Maintain constant real interest rates. Real income can be maintained at a constant level if the nominal income is allowed to adjust in step with the price level. 32. If the nominal interest rate is 10 percent and the real interest rate is 6 percent, The expected rate of inflation is 4 percent. The expected rate of inflation is 6 percent. Real GDP must exceed nominal GDP. Nominal GDP equals real GDP. The expected rate of inflation is equal to the nominal real rate of interest minus the real rate of interest.

16 Page 16 of Consider the economy represented in Figure 7.4. If actual inflation was greater than anticipated inflation, Borrowers would experience a decrease in real income. Lenders would experience a decrease in real income. Lenders would experience an increase in real income. The Federal Reserve would be forced to step in to increase lending. Lenders would be worse off because borrowers would repay their loans with dollars worth less than what they borrowed. Difficulty: 3 Hard

17 Page 17 of The most desirable inflation rate is the rate that Equals the official goal of 3 percent. Has the least effect on the behavior of companies, investors, consumers, and workers. Maximizes the "wealth effect" of inflation. Coincides with an unemployment rate of 0 percent. As long as inflation is low and stable, individuals can easily factor it into their expectations. 35. The core inflation rate excludes Entertainment and packaging prices. Food and energy prices. Only energy prices for the airlines. Import prices. The core inflation rate excludes changes in food and energy prices, which have a lot of month-to-month variation.