Chapter 24. Measuring the Cost of Living.

1. In order to estimate the consumer price index, the Bureau of Labor Statistics:

a. surveys consumers to find the basket of goods and services bought by the typical consumer.Correct. The basket is determined by survey and is fixed in relative amounts.

b. surveys producers to find the basket of goods and services typically sold to consumers.Incorrect. The BLS surveys household consumers.

c. lets the base year fluctuate on an annual basis.

Incorrect. The base year is a fixed date. d. allows the basket of goods and services bought by a typical consumer to change so all substitution bias is eliminated.Incorrect. The basket is determined by survey and is fixed in relative amounts.

2. If nominal interest rates increase from 8 percent to 10 percent while inflation increases from 5 percent to 8 percent:

a. the real interest rate falls from 3% to 2%.

Correct. The formula for the real interest rate is nominal rate minus the inflation rate. In this case the real rate changes from 8 - 5 = 3 to 10 n-8 =2. b. the real interest rate rises from 4% to 2%.Incorrect. The formula for the real interest rate is nominal rate minus the inflation rate. In this case the real rate changes from 8 - 5 = 3 to 10 n-8 =2.

c. the real interest rate falls from 3% to -2%.

Incorrect. The formula for the real interest rate is nominal rate minus the inflation rate. In this case the real rate changes from 8 - 5 = 3 to 10 n-8 =2.

d. the real interest rate rises from 8% to 12%.

Incorrect. The formula for the real interest rate is nominal rate minus the inflation rate. In this case the real rate changes from 8 - 5 = 3 to 10 n-8 =2.

3. Indexation refers to

a. a process of adjusting the nominal interest rate so that it is equal to the real interest rate.Incorrect. Indexation refers to any adjustment of nominal values to real values.

b. using a law or contract to automatically correct a dollar amount for the effects of inflation.Correct. Indexation is a legal contract to adjust a nominal value to a real value.

c. using a price index to deflate dollar values.

Incorrect. Indexation is a legal contract to adjust a nominal value to a real value.

d. an adjustment made by the Bureau of Labor Statistics to the CPI so that the index is in line with the GDP deflator.

Incorrect. The BLS does not adjust the CPI relative to the GDP deflator.

4. Suppose the quality and the price of Ford Mustangs increases over the period 1997-2000. If the CPI does not adjust for the change in quality, the CPI will

a. accurately reflect changes in the cost of living.Incorrect. The CPI will not reflect that consumers are paying for a higher value product.

b. overstate changes in the cost of living.

Correct. The CPI will not reflect that consumers are paying for a higher value product. c. understate changes in the cost of living.Incorrect. The CPI will not reflect that consumers are paying for a higher value product.

d. understate changes in the cost of living, but this will be balanced out because the GDP deflator will overstate changes in the cost of living.

Incorrect. The CPI will not reflect that consumers are paying for a higher value product.

5. The consumer price index

a. measures price changes of raw materials.Incorrect. The CPI measures the cost of final consumer goods and services.

b. adjusts all prices of goods and services for five year periods.Incorrect. There is no fixed period when the base year or market basket is adjusted.

c. measures the cost of goods and services bought by a typical consumer.Correct. The CPI is based on typical consumption patterns of an average consumer.

d. cannot measure price changes of intangible production such as services.

Incorrect. The CPI measures the cost of final consumer goods and services.

6. If the consumer price index (CPI) at the end of 1999 was 125 and the CPI at the end of 2000 was 133, then the rate of inflation over the time period was:

a. zero, prices were stable during the period.Incorrect. . The formula for calculating the percentage change in the CPI is CPI in 2000 minus CPI in 1999/CPI in 1999 x 100. In this case 133 - 125/125 x 100 = 6.4

b. 4.8 percent.Incorrect. . The formula for calculating the percentage change in the CPI is CPI in 2000 minus CPI in 1999/CPI in 1999 x 100. In this case 133 - 125/125 x 100 = 6.4

c. 6.4 percent.Correct. The formula for calculating the percentage change in the CPI is CPI in 2000 minus CPI in 1999/CPI in 1999 x 100. In this case 133 - 125/125 x 100 = 6.4

d. 8 percent.

Incorrect. . The formula for calculating the percentage change in the CPI is CPI in 2000 minus CPI in 1999/CPI in 1999 x 100. In this case 133 - 125/125 x 100 = 6.4

7. In the context of the CPI, which of the following is an example of substitution bias?

a. When new goods are introduced, consumers have greater variety that makes the dollar more valuable.Incorrect. Substitution bias refers to the effects of relative price changes.

b. As prices change, producers substitute resources toward the production of goods whose prices have increased.Incorrect. The CPI is based on consumer spending not producers.

c. As prices change, consumers still buy the same basket of goods and services.

Incorrect. As prices change, consumers substitute less expensive goods for more expensive ones.

d. Consumers substitute toward less expensive goods when prices change.Correct. In this way consumers avoid some of the inflation caused by price increases.

8. Which of the following is correct?

a. The CPI is not based on a fixed basket of goods and services.Incorrect. The CPI is based on a fixed basket.

b. The GDP deflator reflects the prices of all domestically produced goods and services.Correct. GDP is the sum of all domestically produced goods and services and the GDP deflator reflects price changes in all of them.

c. The GDP deflator is based on a fixed basket of goods and services.Incorrect. The GDP deflator is based on a changing basket to minimize substitution bias.

d. The GDP deflator is subject to substitution bias.

Incorrect. The GDP deflator is based on a changing basket to minimize substitution bias.

9. Your grandparents tell you that in 1960 they paid $0.35 for admission to a movie. The price index in 1960 was 30. The price index in today is 171. What is the price your grandparents paid in today's dollars?

a. $1.05Incorrect. The formula for adjusting for price changes is price index today/price index 1960 times the old price. In this case 171/30 x $0.35 = $1.99.

b. $1.99

Correct. The formula for adjusting for price changes is price index today/price index 1960 times the old price. In this case 171/30 x $0.35 = $1.99.

c. $3.01Incorrect. The formula for adjusting for price changes is price index today/price index 1960 times the old price. In this case 171/30 x $0.35 = $1.99.

d. $5.98Incorrect. The formula for adjusting for price changes is price index today/price index 1960 times the old price. In this case 171/30 x $0.35 = $1.99.

10. A change in the price of imports bought by consumers will be

a. reflected in the GDP deflator.Incorrect. Imports are not produced in the U.S. so they would not be included in the U.S. GDP deflator.

b. reflected in GDP.Incorrect. Imports are subtracted from GDP.

c. reflected in the CPI.Correct. Imports are purchased by consumers so they would be in the CPI.

d. reflected in net national income.Incorrect. Imports are subtracted from national income accounts.

11. All of the following are problems associated with the CPI EXCEPT

a. substitution bias.Incorrect. The CPI is subject to consumers substituting less expensive goods for more expensive ones.

b. the introduction of new goods and services.Incorrect. The CPI does not automatically add new goods to its fixed market basket.

c. unmeasured quality changes.Incorrect. It is very difficult to measure quality changes.

d. The CPI is not based on a fixed basket of goods and services.Correct. The CPI is based on a fixed basket of goods and services determined by consumer surveys.

12. Which of the following is true?

a. The CPI tends to underestimate the inflation rate because it fails to consider that consumers will purchase less of those goods and services that increase most in price.Incorrect. The CPI tends to overestimate inflation because it does not account for consumers switching to less expensive goods.

b. The CPI tends to overestimate the inflation rate because it fails to consider that consumers will purchase less of goods and services that increase most in price.Correct. This is the problem of substitution bias that affects the validity of the CPI.

c. The GDP deflator tends to overestimate the inflation rate because it fails to consider that consumers will purchase less of goods and services that increase most in price.

Incorrect. The GDP avoids substitution bias because it is not based on a fixed market basket. d. Both the CPI and GDP deflator implicitly assume that consumers substitute away from goods and services that increase most in price.

Incorrect. The GDP avoids substitution bias because it is not based on a fixed market basket.

13. Which of the following statements is correct?

a. The real rate of interest can not be a negative number.Incorrect. The real rate of interest can be and has been in the past a negative number.

b. The GDP deflator is NOT based on a fixed basket of goods and services.Correct. The GDP deflator reflects changes in the types of goods and services that consumers purchase.

c. The GDP deflator and the CPI typically diverge.Incorrect. The GDP deflator and the CPI track each other rather closely.

d. Changes in quality are fully reflected in the CPI.Incorrect. Changes in quality are very hard to quantify and are imperfectly included in the CPI.

14. Inflation refers to

a. a temporary increase in the price level due to higher tax rates.Incorrect. Inflation can be permanent and can be caused by a multitude of factors.

b. a large increase in food and gasoline prices.Incorrect. Inflation means the price of most goods and services are rising.

c. a situation in which the economy's overall price level is rising.Correct. Inflation is a macroeconomic condition reflecting increases in most prices.

d. an increase in the purchasing power of the dollar.Incorrect. Inflation reduces the purchasing power of the dollar.

15. In order to estimate the consumer price index (CPI), the Bureau of Labor Statistics

a. allows the basket of goods and services used to change from month to month.

Incorrect. The CPI is based on a fixed basket of goods and services. b. chooses a base year.Correct. This is the year that will be the basis for comparing all price changes.

c. determines the prices producers pay for their factors of production.Incorrect. The CPI is based upon prices that consumers pay.

d. determines the goods and services bought by all consumers.Incorrect. The CPI reflects the prices that consumers pay for goods and services they choose to purchase.

16. Suppose the rate of inflation rises from 3 percent to 6 percent. At the same time, nominal rate of interest increases from 5 percent to 10 percent. We know that

a. the real rate of interest will increase.Correct. The formula for the real interest rate is the nominal rate minus the inflation rate. In this case the real rate rises from 2% to 4%, 5% - 3% to 10% - 6%.

b. firms will benefit at the expense of households.Incorrect. We do not know if households are borrowers or lenders in this case.

c. the real rate of interest will not change.Incorrect. The formula for the real interest rate is the nominal rate minus the inflation rate. In this case the real rate rises from 2% to 4%, 5% - 3% to 10% - 6%.

d. the real rate of interest will fall.Incorrect. The formula for the real interest rate is the nominal rate minus the inflation rate. In this case the real rate rises from 2% to 4%, 5% - 3% to 10% - 6%.

17. Which of the following statements is correct?

a. The producer price index is often thought of as a useful predictor of changes in the consumer price index.Correct. The PPI is based upon intermediate resources that will be included in the manufacture of consumer goods.

b. The producer price index measures the cost of a basket of goods and services bought by a typical consumer.

Incorrect. The PPI is not based on consumer purchases. c. The producer price index is based on a basket of goods and services.Incorrect. The PPI is based on the price of intermediate resources.

d. The GDP deflator can be inaccurate because of substitution bias.Incorrect. The GDP is not based on a fixed basket so it is not as susceptible to substitution bias.

18. The price index used to calculate most cost-of-living adjustments (COLAs) is the

a. consumer price index.Correct. The CPI reflects the prices that household consumers pay and these household consumers are receivers of incomes that can be indexed.

b. producer price index.Incorrect. The CPI reflects the prices that household consumers pay and these household consumers are receivers of incomes that can be indexed.

c. GDP deflator.Incorrect. The CPI reflects the prices that household consumers pay and these household consumers are receivers of incomes that can be indexed.

d. NDP deflator.

Incorrect. The CPI reflects the prices that household consumers pay and these household consumers are receivers of incomes that can be indexed.

19. Suppose the CPI in 1990 is 125. The CPI in 2000 is 155. What is the rate of inflation over the period?

a. 24 percentCorrect. The formula for the rate of inflation is the CPI 2000 - CPI 1990/CPI 1990 x 100. In this case, 155 - 125/125 x 100 = 24%.

b. 25 percentIncorrect. The formula for the rate of inflation is the CPI 2000 - CPI 1990/CPI 1990 x 100. In this case, 155 - 125/125 x 100 = 24%.

c. 30 percentIncorrect. The formula for the rate of inflation is the CPI 2000 - CPI 1990/CPI 1990 x 100. In this case, 155 - 125/125 x 100 = 24%.

d. 55 percentIncorrect. The formula for the rate of inflation is the CPI 2000 - CPI 1990/CPI 1990 x 100. In this case, 155 - 125/125 x 100 = 24%.

20. The consumer price index is computed by comparing the cost of the typical market basket of goods purchased during a base year (evaluated at base-year prices) with

a. the cost of the same market basket evaluated at current prices.Correct. The CPI is based on a market basket fixed in the base year.

b. the cost of the current market basket evaluated at base-year prices.Incorrect. The CPI is based on a market basket fixed in the base year.

c. the cost of the current market basket evaluated at current prices.

Incorrect. The CPI is based on a market basket fixed in the base year.

d. the cost of the same market basket evaluated at base-year prices.

Incorrect. The market basket is evaluated at current prices.

21. The price of helicopters purchased by the U.S. military increases. This increase would be reflected

a. in both the CPI and the GDP deflator.Incorrect. Military helicopters are not purchased by consumers and would not be in the CPI.

b. only in the GDP deflator.Correct. The GDP deflator included goods purchased by the government sector.

c. only in the CPI.Incorrect. Military helicopters are not purchased by consumers and would not be in the CPI

d. in neither the CPI nor the GDP deflator.Incorrect. Their price would be included in the GDP deflator but not the CPI.

22. Using the law or a contract to automatically correct a dollar amount for the effects of inflation refers to

a. indexation.Correct. Indexing is typically incorporated into a contract for the payment of incomes and adjusts for price changes.

b. nominal inflation.Incorrect. Indexing is typically incorporated into a contract for the payment of incomes and adjusts for price changes.

c. calculation of the GPI.Incorrect. Indexing is typically incorporated into a contract for the payment of incomes and adjusts for price changes.

d. GDP deflator adjustments.

Incorrect. Indexing is typically incorporated into a contract for the payment of incomes and adjusts for price changes.

23. Substitution bias in the CPI

a. tends to overestimate the cost of living.

Correct. Consumers can avoid some of the impact of higher prices by switching to lower priced goods. b. tends to underestimate the cost of living.Incorrect. Higher prices do not affect consumers as much since consumers can switch to lower priced goods in some cases.

c. has no impact on estimates of the cost of living.Incorrect. Substitution bias overestimates the impact of higher prices.

d. causes decreases in spending.Incorrect. It does not decrease spending but, rather, readjusts it.

24. The GDP deflator

a. includes the prices of all domestically produced goods and services.Correct. GDP includes all domestically produced goods and services so the deflator is based on all domestically produced goods and services.

b. includes the prices of imports bought by domestic consumers.Incorrect. Imports are subtracted, and, therefore, not included in GDP.

c. is based on a fixed basket of goods and services.

Incorrect. The GDP deflator is based on an adjusted mix of goods and services. d. is subject to substitution bias.Incorrect. The GDP deflator is not based on a fixed market basket.

25. Inflation refers to

a. the percentage change in prices brought about by a change in tax rates.Incorrect. Inflation refers to changes in the price level caused by many factors.

b. a situation in which all the prices in the economy are increasing.Incorrect. Inflation refers to a rise in the general or average level of prices.

c. the rate of change in production of a basket of goods and services.Incorrect. Inflation refers to changes in overall prices of goods and services.

d.

a situation in which the economy's overall price level is increasing.Correct. Inflation is a macroeconomic term that reflects the behavior of an average of many prices not on specific prices of goods or services.

26. Economists estimate that the consumer price index overstates inflation each year by about

a. 1-2 percent.Correct. The effect of substitution bias and difficulties in measuring quality changes leads to an overestimate of the rate of inflation by about 1% or 2%.

b. 4-5 percent.Incorrect. The effect of substitution bias and difficulties in measuring quality changes leads to an overestimate of the rate of inflation by about 1% or 2%.

c. 9-10 percent.Incorrect. The effect of substitution bias and difficulties in measuring quality changes leads to an overestimate of the rate of inflation by about 1% or 2%.

d. 10-20 percent.

Incorrect. The effect of substitution bias and difficulties in measuring quality changes leads to an overestimate of the rate of inflation by about 1% or 2%.

27. The price index that measures the cost of a basket of goods and services bought by firms is the

a. CPI (consumer price index).Incorrect. The PPI attempts to measure the intermediate goods and raw materials prices that business firms pay in order to produce final goods and services.

b.

GDP deflator.Incorrect. The PPI attempts to measure the intermediate goods and raw materials prices that business firms pay in order to produce final goods and services.

c. Implicit price deflator.Incorrect. The PPI attempts to measure the intermediate goods and raw materials prices that business firms pay in order to produce final goods and services.

d. PPI (producer price index).Correct. The PPI attempts to measure the intermediate goods and raw materials prices that business firms pay in order to produce final goods and services.

28. In 2000 the nominal rate of interest was 7%. The rate of inflation was 2.7%. The real rate of interest was

a. 9.7 percent.Incorrect. The formula for the real interest rate is the nominal rate minus the rate of inflation. In this case 7.0% minus 2.7% = 4.3%

b. 7 percent.Incorrect. The formula for the real interest rate is the nominal rate minus the rate of inflation. In this case 7.0% minus 2.7% = 4.3%

c. 4.3 percent.Correct. The formula for the real interest rate is the nominal rate minus the rate of inflation. In this case 7.0% minus 2.7% = 4.3%

d. 2.7 percent.

Incorrect. The formula for the real interest rate is the nominal rate minus the rate of inflation. In this case 7.0% minus 2.7% = 4.3%