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If there is 6% inflation, her purchasing power has risen by about 4%. If there is 10% inflation, her purchasing power has remained the same. If there is 12% inflation, her purchasing power has declined by about 2%. If there is 2% deflation, her purchasing power has risen by about 12%.

Definition of nominal interest rate: the interest rate as usually reported without a correction for the effects of inflation. Definition of real interest rate: the interest rate corrected for the effects of inflation.

**real interest rate nominal interest rate inflation rate
**

5.

**Case Study: Interest Rates in the U.S. Economy
**

a. b. c. Figure 3 shows real and nominal interest rates from 1965 to the present. The nominal interest rate is always greater than the real interest rate in this diagram because there was always inflation during this period. Note that in the late 1970s the real interest rate was negative because the inflation rate exceeded the nominal interest rate.

Figure 3

**SOLUTIONS TO TEXT PROBLEMS:
**

Quick Quizzes The answers to the Quick Quizzes can also be found near the end of the textbook. 1. The consumer price index tries to measure the overall cost of the goods and services bought by a typical consumer. It is constructed by surveying consumers to determine a basket of goods and services that the typical consumer buys. Prices of these goods and services are used to compute the cost of the basket at different times, and a base year is chosen. To compute the index, we divide the cost of the market basket in the current year by the cost of the market basket in the base year and multiply by 100. Since Henry Ford paid his workers $5 a day in 1914 and the consumer price index was 10 in 1914 and 195 in 2005, then the Ford paycheck was worth $5 195 / 10 = $97.50 a day in 2005 dollars.

2.

We must now calculate the cost of the market basket in each year: 2006: (50 x $3) + (35 x $4) + (100 x $5) = $790 2007: (50 x $4) + (35 x $4) + (100 x $6) = $940 Then. 35 pounds of chicken. The real interest rate is the nominal interest rate minus the rate of inflation. But the GDP price index is affected. Problems and Applications 1. 3. 2. Find the price of each good in each year: Year 2006 2007 b. which arises because people substitute toward goods that have become relatively less expensive. A 10% increase in the price of chicken has a greater effect on the consumer price index than a 10% increase in the price of caviar because chicken is a bigger part of the average consumer's market basket. the real price (the price adjusted for inflation) of the candy bar tripled. Because the overall price level doubled. a. 2. a. we can compute the CPI in each year: 2006: $790/$790 x 100 = 100 2007: $940/$790 x 100 = 119 c. The three problems in the consumer price index as a measure of the cost of living are: (1) substitution bias. . The real interest rate is the rate of interest corrected for inflation. Ham $3 $4 Chicken $4 $4 Roast Beef $5 $6 If 2006 is the base year. The percentage change in the price of Gatorade is (2 – 1)/1 × 100% = 100%. which are not reflected quickly in the CPI. because Navy submarines are included in GDP as a part of government purchases. 3. The cost of the market basket in 2007 is ($2 × 100) + ($6 × 100) + ($2 × 200) = $200 b. the market basket used to compute the CPI is 50 pounds of ham. The cost of the market basket in 2006 is ($2 × 100) + ($4 × 100) + ($1 × 200) = $200 + $400 + $200 = $800. (2) the introduction of new goods. because Navy submarines are not consumer goods. and (3) unmeasured quality change. there is no effect on the consumer price index. The nominal interest rate is the rate of interest paid on a loan in dollar terms. 5. The percentage change in the price of tennis balls is (2 – 2)/2 × 100% = 0%. and 100 pounds of roast beef. The percentage change in the price of golf balls is (6 – 4)/4 × 100% = 50%. but the price of the candy bar rose sixfold. We can use the CPI to compute the inflation rate for 2007: (119 − 100)/100 x 100% = 19% Many answers are possible. using 2006 as the base year.10 Chapter 24/Measuring the Cost of Living Questions for Review 1. 4. If the price of a Navy submarine rises.

the real interest rate is lower than expected. a. If inflation turns out to be 5%. so consumers are worse off. More flavors enhance consumers’ well-being. so the nominal interest rate is 7%. The percentage change in the cost of the market basket from 2006 to 2007 is (1. Workers' purchasing power fell in terms of newspapers. This would lower my estimation of the inflation rate because the value of a bottle of Gatorade is now greater than before. c.200. In deciding how much income to save for retirement. b. Thus. you would need to put together a market basket for the elderly. In this case.15)/$0. the real interest rate is 7% minus 5% equals 2%. workers should consider the real interest rate. substitution bias a. For example. e. inflation increased people's nominal incomes. so they had to pay a higher proportion of their incomes in taxes.32/60) = 3.Chapter 24/Measuring the Cost of Living 11 + $600 + $400 = $1.200 – 800)/800 × 100% = 50%. c. 7. . d. real tax revenue rose. ($0. In 1970: $0.32 − $3. b.23/60) = 2. The problem is that the increased cost might exceed the value of the improvement in air quality. not the number of dollars they will have. unmeasured quality change. a. a. Social Security would provide the elderly with an improvement in their standard of living each year because the CPI overstates inflation and Social Security payments are tied to the CPI.8 minutes. The argument in favor of this is that consumers are getting a better good than before. b. When inflation is higher than was expected. it would be better for the CPI to at least partially reflect the higher cost. As a result.1 minutes. because they care about their purchasing power in the future. even though they were not getting higher real incomes. suppose the market equilibrium has an expected real interest rate of 3% and people expect inflation to be 4%. which is less than 9.15 x 100% = 400%. You would then compare the rise in the cost of the "elderly" basket with that of the general basket for CPI. 5.23 x 100% = 343%. this would be considered a change in quality and would also lower my estimate of the inflation rate. b. so the price increase equals the improvement in quality. 10.75 − $0. 8. Because the elderly consume more health care than younger people do. The comparison should be made on a per-ounce basis. it is possible that the elderly are worse off. introduction of new goods. a. 6. and because health care costs have risen faster than overall inflation. unmeasured quality change. ($14. Because the increase in cost was considered a quality improvement. d. If the elderly consume the same market basket as other people. In 2000: $0. When bracket creep occurred. pushing them into higher tax brackets. To investigate this.75/($14. there was no increase registered in the CPI. substitution bias.15/($3. c. 4. d. which would have a higher weight on health care.23)/$3.

c. b. Homeowners in the 1970s who had fixed-rate mortgages from the 1960s benefited from the unexpected inflation. The borrower is repaying the loan with dollars that are worth less than was expected. Because the real interest rate is lower than was expected. the lender loses and the borrower gains. .12 Chapter 24/Measuring the Cost of Living the 3% that was expected. while the banks that made the mortgage loans were harmed.

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