Inflation: Answers: 1. D) 2. A) 3. B) 4. C) 5. A)

Inflation
Multiple choice questions:

1. Which of the following can start an inflation?
A) an increase in aggregate demand
B) an increase in aggregate supply
C) a decrease in aggregate supply
D) both answers A and C are correct.
2. Which of the following could start a demand-pull inflation?

A) an increase in government expenditure
B) an increase in taxes
C) a decrease in the quantity of money
D) an increase in the money prices of raw materials
3. Cost-push inflation can be started by

A) a decrease in the money wage rate.
B) an increase in the money prices of raw materials.
C) an increase in the quantity of money.
D) a decrease in government expenditure on goods and services.
4. Stagflation occurs when the price level ________ and real GDP ________.
A) falls; increases
B) falls; decreases
C) rises; decreases
D) rises; increases
5. If the CPI is 110 one year and 120 the next, the annual rate of inflation measured by
the CPI is approximately:
A) 9,09 %
B) 10 %
C) 8,33 %
D) 20 %
Answers: 1. D); 2. A); 3. B); 4. C); 5. A)
Problem solving questions:

1. A typical family on Sandy Island consumes only juice and cloth. Last year, which was
the base year, the family spent $40 on juice and $25 on cloth. In the base year, juice was
$4 a bottle and cloth was $5 a length. This year, juice is $4 a bottle and cloth is $6 a
length. Calculate:
a) The consumer basket.
b) The CPI in the current year.
c) The inflation rate in the current year.
Answer:
First we have to determine the quantities of juice and cloth, which are included in the
consumer basket:
Quantity of juice (Qj) = Spending on juice/Price of juice = $40/$4 = 10
Quantity of cloth (Qc) = Spending on cloth/Price of cloth = $25/$5 = 5
Then we have to find the cost of the basket in both years:

Cost of basket (base year) = Pj(base year) x Qj(base year) + Pc(base year) x Qc(base year)
= 4x10 + 5x5 = 40 + 25 = $65
Cost of basket (current year) = Pj(current year) x Qj(base year) + Pc(current year) +
Qc(base year) = 4x10 + 6x5 = 40 + 30 = $70.
 Note that in the calculations of the cost of the basket for each year the quantities of both
goods are the same, i.e. these are the quantities from the base year. By keeping quantities
constant, we can focus on the change in prices. The fact that the cost of the basket increases
means that for the same basket, the household has to spend more money.
Consumer basket (1 st year ) 65

CPI(1st year) = .100= .100 = 100
Consumer basket (base year) 65
Consumer basket (current year )

b) CPI (current year) = .100
Consumer basket (base year )
70
CPI (current year) = .100 = 107,69
65
CPI ( current year )−CPI (base year )

c) Inflation rate = .100
CPI (base year )
107,69−100
Inflation rate = .100= 7,69 %
100
2. The cost of the consumer basket in 2018 is $1000. If 2018 is the base year and the CPI
in 2019 is 120, compute:
a) the cost of the consumer basket in 2019
b) the inflation rate.
Answer:
Consumer basket (2019)
a) CPI(2019) = .100
Consumer basket (2018)
CPI ( 2019 ) x Consumer basket (2018) 120 x 1000

Consumer basket(2019) = = = $1200
100 100
CPI ( current year )−CPI (base year )

b) Inflation rate = .100
CPI (base year )
120−100
Inflation rate = .100= 20 %
100
/CPI in the base year is always 100./
3. EUROSTAT reported the following information about the Consumer Price Index.
Region 2017 2018

European Union 101,96 103,89
United States 102,29 104,52
Turkey 119,63 139,17
Calculate the inflation rate in 2018 in each region/country. Where was the inflation rate the
highest?
Answer:
CPI (2018)−CPI (2017) 103,89−101,96
- EU: Inflation rate = .100 = .100 = 1,89 %
CPI (2017) 101,96
CPI (2018)−CPI (2017) 104,52−102,29

- United States: Inflation rate= .100 = .100 =
CPI ( 2017) 102,29
2,18%
CPI (2018)−CPI (2017) 139,17−119,63

- Turkey: Inflation rate= .100 = .100 = 16,33 %
CPI ( 2017) 119,63
4. A consumer’s nominal income in the current year is $45 000. Last year his nominal
income was $42 000. The CPI in the current year is 115, compared to 100 in the previous
year.
a) Calculate the real income of the consumer in the current year and the inflation rate.
b) What will be the real income in the current year if CPI is 107,14?
Answer:
Nominal income(current year )
a) Real income (current year) = .100
CPI (current year )
45 000
Real income (current year) = .100 = $39 130,4
115
 Note the following:

Nominal income ( current year ) −Nominal income(base year )
Change in nominal income=
Nominal income(base year )
.100 =
45 000−42 000
.100 = 7,14 %
42 000
CPI ( current year )−CPI (base year ) 115−100
In the same time the inflation rate = .100 =
CPI (base year ) 100
.100 = 15 %
The increase in the price level is higher than the increase in the nominal income. That is why
there is a decrease in real income.
b) If CPI in the current year was 107,14, this would mean the inflation rate would be 7,14 %,
which is the same as the increase in the nominal income. Therefore real income would not
change and it would be around $42 000. We can find this by using the formula as well:
Nominal income(current year ) 45 000

Real income (current year) = .100 = .100 = $42 001,1
CPI (current year ) 107,14
5. Suppose that a borrower and a lender agree on the nominal interest rate to be paid on
a loan (7%). They expect inflation to be 4 %. However, inflation turns out to be higher
than they both expected (5%).
a) Is the real interest rate on this loan higher or lower than expected?
b) Does the lender gain or lose from this unexpectedly high inflation? Does the borrower gain
or lose?
Answer:
a) Real interest rate = Nominal interest rate – Inflation
Suppose that the agreed nominal interest rate is 7 % and that people expect inflation to be
4 %  The expected real interest rate is: 7 – 4 = 3 %.
Then inflation turns out to be higher than expected, for example 5 %. This means that the real
interest rate becomes: 7 – 5 = 2 %.
 Hence, the real interest rate on the loan is lower than expected.
b) The lender loses, while the borrower gains (The borrower is repaying the loan with dollars
that are worth less than was expected).

Inflation: Answers: 1. D) 2. A) 3. B) 4. C) 5. A)

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Inflation

Multiple choice questions:

2. Which of the following could start a demand-pull inflation?

3. Cost-push inflation can be started by

Answers: 1. D); 2. A); 3. B); 4. C); 5. A)

Problem solving questions:

Then we have to find the cost of the basket in both years:

Consumer basket (1 st year ) 65

Consumer basket (current year )

CPI ( current year )−CPI (base year )

CPI ( 2019 ) x Consumer basket (2018) 120 x 1000

CPI ( current year )−CPI (base year )

Region 2017 2018

CPI (2018)−CPI (2017) 104,52−102,29

CPI (2018)−CPI (2017) 139,17−119,63

 Note the following:

Nominal income(current year ) 45 000

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