Inflation

1.Answer the next four questions based on the following data using year 1 as the base year. All dollars are in
billions. Calculate to one decimal place.
Year CPI
1 160
2 165
3 170
4 177

(a) What was the percentage rise in prices between years 1 and 2?
(b) What was the percentage rise in prices between years 2 and 3?
(c) What was the percentage rise in prices between years 3 and 4?

(a) 3.1% (165 minus 160 divided by 160 equals .031. 0.031  100 = 3.1%
(b) 3.0% (170 minus 165) divided by 165 equals 0.030. 0.030  100 = 3.0%
(c) 3.0% (177 minus 170) divided by 170 equals 0.041. 0.041  100 = 4.1%

2. Calculate the rate of inflation between Year 1 and Year 2. The price index in Year 1 was 124.0. It was
130.7 in Year 2.

Subtract 130.7 minus 124.0 = 6.7; Divide 6.7 by 124.0 (since that is the index in the comparison year in this
problem). 6.7/124 = 0.0540; Multiply 0.0540 by 100 to change to percentage terms and get 5.4% as the
rate of inflation between Year 1 and Year 2.

3. The table below shows the price index in the economy at the end of four different years. (a) What is the
rate of inflation in years 2, 3, and 4? ?
Rate of
Year Price index inflation
1 100
2 108 _____
3 120 _____
4 132 _____

Rate of
Year Price index inflation
1 100
2 108 8.0%
3 120 11.1
4 132 10.0

(a) To get the rate of inflation, subtract last year’s index from this year’s index (108 − 100 for year 2);
divide this result (8) by last year’s index (100) to get 0.08; multiply by 100 to change to percent (8%).
(b)

4.Inflation is frequently described as ―too much money chasing too few goods.‖ Is this an acceptable
definition?

This does not really define inflation completely. However, it does give anyone who has knowledge of the
relationship between prices and money supply a good idea of the demand-pull cause of inflation, and,
therefore, an understanding of the concept. The more money there is relative to the amount of goods and
services available, the greater will be the price level. This is an easy notion to grasp for most people, but it
is not a technical definition of inflation.

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5.What is ―demand-pull‖ inflation?

―Demand-pull‖ inflation is the traditional view that inflation is caused by growing total demand bidding up
the prices of output in a period of nearly full or full employment.

6.Describe cost-push inflation and its major source.

Cost-push or supply-side inflation is caused by the per-unit cost of production rising so that costs push up
prices for firms to maintain profitability. A major source of this type of inflation comes from so-called
supply shocks. The supply shocks refer to situations in resource markets such as the oil crises of 1973–
1974 and 1979–1980 when imported oil prices rose dramatically and pushed up energy costs for production
and transportation.

7. What is core inflation? Why is it used?

Core inflation refers to the calculation of inflation without food and energy items included in the price
index. The reason that food and energy prices are removed from the inflation calculation is that they are
quite volatile and thus mask what the underlying inflation rate is for core items in the price index.

8.Answer the next four questions based on the following data using year 1 as the base year. All dollars are in
billions.
Year Nominal income CPI
1 $3166 100
2 3402 104
3 3774 108
4 3989 112

(a) Find real income in year 4.

(b) What was the percentage rise in prices between years 1 and 3?
(c) What was the percentage rise in prices between years 2 and 4?
(d) What was the increase in real income from year 3 to year 4 in percentage?

(a) $3562 = 3989/1,12

(b) 8%= [108-100]/100
(c) (112 minus 104) divided by 104 equals 0.077. 0.077  100 = 7.7%
(d) Find real income for years 3 and 4. Subtract the two figures and divide by real income in year 3.
Multiply by 100 to express in percent.

Year 3  3774/1,08 = 3494

Year 4  3989/1,12 = $3562
Result is $3562 − $3494 = $68
$68/ $3494 = 0.019;
0.019  100 = 1.9% growth in real income.

9.Answer the next four questions based on the following data using year 1 as the base year. All dollars are in
billions.
Year Nominal income CPI
1 $50,000 100
2 60,000 110
3 70,000 115
4 80,000 120

(a) Find real income in year 2.

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(b) What was the percentage rise in prices between years 2 and 3?
(c) What was the percentage rise in prices between years 3 and 4?
(d) What was the increase in real income from year 3 to year 4 in percentage?

(a) $54,545 ($60,000/ 1.10)

(b) (115 minus 110) divided by 110 equals 0.045. 0.045  100 = 4.5%
(c) (120 minus 115) divided by 115 equals 0.042. 0.042  100 = 4.2%
(d) Find real income for years 3 and 4. Subtract the two figures and divide by real income in year 3.
Multiply by 100 to express in percent.

Year 3  70000/1,15= 60870

Year 4  80000/1,2= 66667
Result is $66667 − $60870 = $5797;
$5797/ $60870 = 0.095;
0.095  100 = 9.5% growth in real income.

10.Assume that nominal income is $35,000 and the price index is 1.20 in year 1. In year 2, nominal income
rises to $38,000 and the price index rises to 1.25. What was the percentage change in real income from
year 1 to year 2? What was the absolute amount of increase in real income? Make your calculations of the
percentage change in real income and the absolute change in real income using the approximation formula
and using the more precise method with index numbers.

First, calculate the percentage change by the approximation formula. Nominal income has increased by
8.6% [($3000/$35,000)  100]. The price level has increased by 4.2% [(.05/1.20)  100]. The percentage
change in real income was approximately 4.4% (8.6% − 4.2%). To calculate the amount of the absolute
increase in real income, multiply 4.4% times $35,000, which equals $1540.
The more precise calculation would use index numbers. Real income in year 1 was $29,166.7 ($35,000 /
1.20). Real income in year 2 was $30,400 ($38,000/1.25). The absolute change in real income was
$1233.3. The percentage change in real income was 4.2% [($1233/ $29,166)  100].

11.Explain the difference between real and nominal income. How can you get an approximation of the
percentage change in real income from one time period to another?

Real income is determined by dividing nominal income by the price level expressed in hundredths. The
percentage change in real income can be approximated by subtracting the percentage change in the price
level from the percentage change in nominal income.

12.―Unexpected inflation is more beneficial to those who save than those who borrow.‖ Evaluate this
statement. How does your answer change if the inflation is expected?

The statement is incorrect. Savers are actually hurt by unexpected inflation because it reduces the real rate
of return they receive on their savings, or if they don’t receive a rate of return on their savings, it reduces
the purchasing power of their savings. Borrowers actually benefit from unexpected inflation because it
reduces the amount they have to pay back because dollars are cheaper due to the inflation. However, if
inflation is expected, inflation does not hurt the saver or benefit the borrower. Anticipating the rate of
inflation permits savers to make adjustments in their savings—like requiring a higher interest rate on
savings accounts—to allow for inflation. Borrowers do not benefit because lenders allow for inflation in
their borrowing agreements.

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