Chapter 24 Measuring the Cost of Living

MULTIPLE CHOICE

1. The consumer price index is used to

a. monitor changes in the level of wholesale prices in the economy.
b. monitor changes in the cost of living over time.
c. monitor changes in the level of real GDP over time.
d. monitor changes in the stock market.
ANS: B PTS: 1 DIF: 1 REF: 11-0

2. Which of the following is correct?

a. The GDP deflator is better than the CPI at reflecting the goods and services bought by
consumers.
b. The CPI is better than the GDP deflator at reflecting the goods and services bought by
consumers.
c. The GDP deflator and the CPI are equally good at reflecting the goods and services bought
by consumers.
d. The GDP deflator is more commonly used as a gauge of inflation than the CPI is.
ANS: B PTS: 1 DIF: 2 REF: 11-0

THE CONSUMER PRICE INDEX

3. The CPI is a measure of the overall cost of the goods and services bought by
a. a typical consumer, and the CPI is computed and reported by the Department of the
Treasury.
b. typical consumers and typical business firms, and the CPI is computed and reported by the
Department of the Treasury.
c. a typical consumer, and the CPI is computed and reported by the Bureau of Labor
Statistics.
d. typical consumers and typical business firms, and the CPI is computed and reported by the
Bureau of Labor Statistics.
ANS: C PTS: 1 DIF: 2 REF: 11-1

4. The steps involved in calculating the consumer price index and the inflation rate, in order, are as
follows:
a. Choose a base year, update the basket, find the prices, estimate the basket’s cost, compute
the index, and compute the inflation rate.
b. Choose a base year, fix the basket, find the prices, compute the inflation rate, compute the
basket's cost, and compute the index.
c. Fix the basket, find the prices, compute the basket's cost, choose a base year and compute
the index, and compute the inflation rate.
d. Fix the basket, find the prices, compute the inflation rate, compute the basket’s cost, and
choose a base year and compute the index.
ANS: C PTS: 1 DIF: 1 REF: 11-1

5. In the calculation of the CPI, books are given greater weight than magazines if
a. consumers buy more books than magazines.
b. the price of books is higher than the price of magazines.
c. it costs more to produce books than it costs to produce magazines.
 d. books are more readily available than magazines to the typical consumer.
ANS: A PTS: 1 DIF: 2 REF: 11-1

6. What basket of goods and services is used to construct the CPI?

a. a random sample of all goods and services produced in the economy
b. the goods and services that are typically bought by consumers as determined by
government surveys
c. only food, clothing, transportation, entertainment, and education
d. the least expensive and the most expensive goods and services in each major category of
consumer expenditures
ANS: B PTS: 1 DIF: 2 REF: 11-1

7. When computing the cost of the basket of goods and services purchased by a typical consumer,
which of the following changes from year to year?
a. the quantities of the goods and services purchased
b. the prices of the goods and services
c. the goods and services making up the basket
d. All of the above are correct.
ANS: B PTS: 1 DIF: 2 REF: 11-1

8. The inflation rate is calculated

a. by determining the change in the price index from the preceding period.
b. by adding up the price increases of all goods and services.
c. by computing a simple average of the price increases for all goods and services.
d. by determining the percentage increase in the price index from the preceding period.
ANS: D PTS: 1 DIF: 1 REF: 11-1

9. If 2004 is the base year, then the inflation rate for 2005 equals
a.

b.

c.

d.

ANS: A PTS: 1 DIF: 2 REF: 11-1

10. If the consumer price index was 100 in the base year and 107 in the following year, then the
inflation rate was
a. 1.07 percent.
b. 7 percent.
c. 10.7 percent.
d. 107 percent.
ANS: B PTS: 1 DIF: 2 REF: 11-1

11. From 2008 to 2009, the CPI for medical care increased from 150.8 to 164.4. What was the
inflation rate for medical care?
a. 4.4 percent
 b. 7.6 percent
c. 9.0 percent
d. 12.1 percent
ANS: C PTS: 1 DIF: 2 REF: 11-1

12. The price index was 110 in the first year, 100 in the second year, and 96 in the third year. The
economy experienced
a. 9.1 percent deflation between the first and second years, and 4 percent deflation between
the second and third years.
b. 9.1 percent deflation between the first and second years, and 4.2 percent deflation between
the second and third years.
c. 10 percent deflation between the first and second years, and 4 percent deflation between
the second and third years.
d. 10 percent deflation between the first and second years, and 4.2 percent deflation between
the second and third years.
ANS: A PTS: 1 DIF: 2 REF: 11-1

13. Which of the following changes in the price index produces the greatest rate of inflation: 80 to 100,
100 to 120, or 150 to 170?
a. 80 to 100
b. 100 to 120
c. 150 to 170
d. All of these changes produce the same rate of inflation.
ANS: A PTS: 1 DIF: 2 REF: 11-1

14. The price index was 128.96 in 2006, and the inflation rate was 24 percent between 2005 and 2006.
The price index in 2005 was
a. 104.
b. 104.96.
c. 152.96.
d. 159.91.
ANS: A PTS: 1 DIF: 2 REF: 11-1

15. Suppose the price index was 105 in 2007, 115.5 in 2008, and the inflation rate was lower between
2008 and 2009 than it was between 2007 and 2008. This means that
a. the price index in 2009 was lower than 115.5.
b. the price index in 2009 was lower than 126.
c. the price index in 2009 was lower than 127.05.
d. the inflation rate between 2008 and 2009 was lower than 1.1 percent.
ANS: C PTS: 1 DIF: 3 REF: 11-1

16. For an imaginary economy, the consumer price index was 115.00 in 2004, 126.50 in 2005, and
136.62 in 2006. Which of the following statements is correct?
a. For this economy, the base year must be 2004.
b. If the basket of goods that is used to calculate the CPI cost $75.00 in the base year, then
that basket of goods cost $115.00 in 2004.
c. This economy’s rate of inflation for 2006 is 10.12 percent.
d. None of the above is correct.
ANS: D PTS: 1 DIF: 3 REF: 11-1
17. The producer price index measures the cost of a basket of goods and services
a. typically produced in the economy.
b. produced for a typical consumer.
c. sold by producers.
d. bought by firms.
ANS: D PTS: 1 DIF: 1 REF: 11-1

18. Suppose that in 2010, the producer price index increases by 1.5 percent. As a result, economists
most likely will predict that
a. GDP will increase in 2011.
b. the producer price index will increase by more than 1.5 percent in 2011.
c. interest rates will decrease in the future.
d. the consumer price index will increase in the future.
ANS: D PTS: 1 DIF: 2 REF: 11-1

19. By far the largest category of goods and services in the CPI basket is
a. housing.
b. transportation.
c. education & communication.
d. food & beverages.
ANS: A PTS: 1 DIF: 1 REF: 11-1

20. In the basket of goods that is used to compute the consumer price index, the three largest
categories of consumer spending are
a. housing, transportation, and recreation.
b. housing, transportation, and food & beverages.
c. housing, food & beverages, and education & communication.
d. housing, medical care, and education & communication.
ANS: B PTS: 1 DIF: 2 REF: 11-1

21. If the cost of transportation increases by 20 percent, then, other things the same, the CPI is likely to
increase by about
a. 0.3 percent.
b. 1.7 percent.
c. 3.4 percent.
d. 10 percent.
ANS: C PTS: 1 DIF: 3 REF: 11-1

22. The consumer price index tires to measure how much consumer incomes must rise in order to
maintain a constant
a. level of real GDP.
b. ratio of consumption to GDP.
c. ratio of net exports to GDP.
d. standard of living.
ANS: D PTS: 1 DIF: 2 REF: 11-1

23. When the relative price of a good increases, consumers respond by buying
a. a larger quantity of that good and a larger quantity of substitutes for that good.
b. a larger quantity of that good and a smaller quantity of substitutes for that good.
c. a smaller quantity of that good and a larger quantity of substitutes for that good.
 d. a smaller quantity of that good and a smaller quantity of substitutes for that good.
ANS: C PTS: 1 DIF: 2 REF: 11-1

24. One problem with the consumer price index stems from the fact that, over time, consumers tend to
buy larger quantities of goods that have become relatively less expensive and smaller quantities of
goods that have become relatively more expensive. This problem is called
a. price-change neglect.
b. unmeasured quality change.
c. substitution bias.
d. relative bias.
ANS: C PTS: 1 DIF: 1 REF: 11-1

25. The substitution bias in the consumer price index refers to the
a. substitution by consumers toward new goods and away from old goods.
b. substitution by consumers toward a smaller number of high-quality goods and away from
a larger number of low-quality goods.
c. substitution by consumers toward goods that have become relatively less expensive and
away from goods that have become relatively more expensive.
d. substitution of new prices for old prices in the CPI basket of goods and services from one
year to the next.
ANS: C PTS: 1 DIF: 2 REF: 11-1

26. Assume that consumers consider rice and potatoes to be substitutes, so that when the price of rice
rises, consumers purchase less rice and more potatoes. When the CPI is computed following the
increase in the price of rice, it takes into account
a. the increase in the price of rice.
b. the decrease in the quantity of rice purchased and the increase in the quantity of potatoes
purchased.
c. Both (a) and (b) are correct.
d. None of the above is correct.
ANS: A PTS: 1 DIF: 2 REF: 11-1

27. By not taking into account the possibility of consumer substitution, the CPI
a. understates the cost of living.
b. overstates the cost of living.
c. may overstate or understate the cost of living, depending on how quickly prices rise.
d. may overstate or understate the cost of living, regardless of how quickly prices rise.
ANS: B PTS: 1 DIF: 2 REF: 11-1

28. One of the widely acknowledged problems with using the consumer price index as a measure of
the cost of living is that the CPI
a. fails to account for consumer spending on housing.
b. accounts only for consumer spending on food, clothing, and energy.
c. fails to account for the fact that consumers spend larger percentages of their incomes on
some goods and smaller percentages of their incomes on other goods.
d. fails to account for the introduction of new goods.
ANS: D PTS: 1 DIF: 2 REF: 11-1

29. To which of the problems in the construction of the CPI is the creation of the mobile phone most
relevant?
 a. substitution bias
b. introduction of new goods
c. unmeasured quality change
d. income bias
ANS: B PTS: 1 DIF: 2 REF: 11-1

30. Several studies in the 1990s concluded that the consumer price index overstated inflation by about
a. 3 percentage points per year, and that number of percentage points likely still applies now.
b. 3 percentage points per year, but recent improvements to the CPI probably have reduced
the overstatement of inflation to something less than 3 percentage points.
c. 1 percentage point per year, and that number of percentage points likely still applies now.
d. 1 percentage point per year, but recent improvements to the CPI probably have reduced
the overstatement of inflation to something less than 1 percentage point
ANS: D PTS: 1 DIF: 2 REF: 11-1

31. A decrease in the price of domestically produced industrial robots will be reflected in
a. both the GDP deflator and the consumer price index.
b. neither the GDP deflator nor the consumer price index.
c. the GDP deflator but not in the consumer price index.
d. the consumer price index but not in the GDP deflator.
ANS: C PTS: 1 DIF: 2 REF: 11-1

32. Which of the following statements is true?

a. Even if we know the values of the consumer price index for the years 2009 and 2010, we
cannot calculate the inflation rate for 2010 if we do not know which year is the base year.
b. If we know the base year is 1990, and if we know the value of the consumer price index
for the year 2010, then we have all the information we need to calculate the inflation rate
for 2010.
c. If we know the base year is 2000, and if we know the value of the consumer price index
for the year 1995, then we have all the information we need to calculate the inflation rate
for 1995.
d. If we know the base year is 2000, and if we know the value of the consumer price index
for the year 1995, then we have all the information we need to calculate the percentage
change in the cost of living between 1995 and 2000.
ANS: D PTS: 1 DIF: 3 REF: 11-1

33. Suppose the quality of beef changes over time, but the quality change goes unmeasured for the
purpose of computing the consumer price index. In which of the following instances would the
bias resulting from the unmeasured quality change be least severe?
a. The quality of beef deteriorates and beef becomes more expensive relative to other goods.
b. The quality of beef deteriorates and beef becomes less expensive relative to other goods.
c. The quality of beef improves and beef becomes more expensive relative to other goods.
d. The quality of beef improves and the price of beef relative to other prices remains
unchanged.
ANS: A PTS: 1 DIF: 2 REF: 11-1

CORRECTING ECONOMIC VARIABLES FOR THE EFFECTS OF INFLATION

34. The primary purpose of measuring the overall level of prices in the economy is to
a. allow for the measurement of GDP.
 b. allow consumers to know what kinds of prices to expect in the future.
c. allow for the comparison of dollar figures from different points in time.
d. allow for the comparison of dollar figures from the same point in time.
ANS: C PTS: 1 DIF: 1 REF: 11-2

35. In 1970, Professor Plum earned 12,000 dinars; in 1980, he earned 24,000; and in 1990, he earned
36,000. If the CPI was 40 in 1970, 60 in 1980, and 100 in 1990, then in real terms, Professor
Plum's salary was highest in
a. 1980 and lowest in 1970.
b. 1980 and lowest in 1990.
c. 1990 and lowest in 1970.
d. 1990 and lowest in 1980.
ANS: A PTS: 1 DIF: 3 REF: 11-2

36. Suppose the CPI was 108 in 1967, and suppose one must spend 936 dollars today to obtain the
same basket of goods and services that could be bought for 200 dollars in 1967. Then today’s CPI
is
a. 116.67.
b. 131.08.
c. 397.44.
d. 505.44.
ANS: D PTS: 1 DIF: 2 REF: 11-2

37. Which of the following statements is correct about the relationship between inflation and interest
rates?
a. There is no relationship between inflation and interest rates.
b. The interest rate is determined by the rate of inflation.
c. In order to fully understand inflation, we need to know how to correct for the effects of
interest rates.
d. In order to fully understand interest rates, we need to know how to correct for the effects
of inflation.
ANS: D PTS: 1 DIF: 2 REF: 11-2

38. Which of the following statements is correct about the relationship between the nominal interest
rate and the real interest rate?
a. The real interest rate is the nominal interest rate times the rate of inflation.
b. The real interest rate is the nominal interest rate minus the rate of inflation.
c. The real interest rate is the nominal interest rate plus the rate of inflation.
d. The real interest rate is the nominal interest rate divided by the rate of inflation.
ANS: B PTS: 1 DIF: 1 REF: 11-2

39. The nominal interest rate tells you

a. how fast the number of dollars in your bank account rises over time.
b. how fast the purchasing power of your bank account rises over time.
c. the number of dollars in your bank account today.
d. the purchasing power of your bank account today.
ANS: A PTS: 1 DIF: 1 REF: 11-2

40. The real interest rate tells you

a. how fast the number of dollars in your bank account rises over time.
 b. how fast the purchasing power of your bank account rises over time.
c. the number of dollars in your bank account today.
d. the purchasing power of your bank account today.
ANS: B PTS: 1 DIF: 1 REF: 11-2

41. As long as prices are rising over time, then

a. the nominal interest rate exceeds the real interest rate.
b. the real interest rate exceeds the nominal interest rate.
c. the real interest rate is positive.
d. the nominal interest rate is a better indicator than the real interest rate of how fast the
purchasing power of your bank account is changing over time.
ANS: A PTS: 1 DIF: 2 REF: 11-2

42. If the nominal interest rate is 8 percent and the rate of inflation is 3 percent, then the real interest
rate is
a. -5 percent.
b. 1.67 percent.
c. 5 percent.
d. 11 percent.
ANS: C PTS: 1 DIF: 2 REF: 11-2

43. If the nominal interest rate is 8 percent and the real interest rate is 5.5 percent, then the inflation
rate is
a. -2.5 percent.
b. 0.45 percent.
c. 2.5 percent.
d. 13.5 percent.
ANS: C PTS: 1 DIF: 2 REF: 11-2

44. The consumer price index was 225 in 2006 and 234 in 2007. The nominal interest rate during this
period was 6.5 percent. What was the real interest rate during this period?
a. 2.5 percent
b. 4.0 percent
c. 6.76 percent
d. 10.5 percent
ANS: A PTS: 1 DIF: 3 REF: 11-2

45. The CPI was 120 in 2008 and 126 in 2009. Phil borrowed money in 2008 and repaid the loan in
2009. If the nominal interest rate on the loan was 8 percent, then the real interest rate was
a. -2 percent.
b. 3 percent.
c. 5 percent.
d. 13 percent.
ANS: B PTS: 1 DIF: 3 REF: 11-2

46. Suppose that over the past year, the real interest rate was 5 percent and the inflation rate was 3
percent. It follows that
a. the value of savings increased at 5 percent, and the purchasing power of savings increased
at 2 percent.
b. the value of savings increased at 5 percent, and the purchasing power of savings increased
 at 8 percent.
c. the value of savings increased at 8 percent, and the purchasing power of savings increased
at 2 percent.
d. the value of savings increased at 8 percent, and the purchasing power of savings increased
at 5 percent.
ANS: D PTS: 1 DIF: 2 REF: 11-2

47. Jake loaned Elwood 5,000 dollars for one year at a nominal interest rate of 10 percent. After
Elwood repaid the loan in full, Jake complained that he could buy 4 percent fewer goods with the
money Elwood gave him than he could before he loaned Elwood the money. From this, we can
conclude that the rate of inflation during the year was
a. -4 percent.
b. 4 percent.
c. 6 percent.
d. 14 percent.
ANS: D PTS: 1 DIF: 2 REF: 11-2

48. Which of the following is correct?

a. Nominal and real interest rates always move together.
b. Nominal and real interest rates never move together.
c. Nominal and real interest rates do not always move together.
d. Nominal and real interest rates always move in opposite directions.
ANS: C PTS: 1 DIF: 2 REF: 11-2

49. When looking at a graph of nominal and real interest rates you notice that nominal rates always lie
above real rates. From this you conclude
a. there were serious episodes of deflation in the time frame represented on the graph.
b. consumer prices were always rising in the time frame represented on the graph.
c. the economy never experienced a recession in the time frame represented on the graph.
d. GDP was always increasing for the time frame represented on the graph.
ANS: B PTS: 1 DIF: 3 REF: 11-2

50. Indexation refers to

a. a process of adjusting the nominal interest rate so that it is equal to the real interest rate.
b. using a law or contract to automatically correct a dollar amount for the effects of inflation.
c. using a price index to deflate dollar values.
d. an adjustment made by the Bureau of Labor Statistics to the CPI so that the index is in line
with the GDP deflator.
ANS: B PTS: 1 DIF: 1 REF: 11-2

TRUE/FALSE

1. The consumer price index is used to monitor changes in an economy’s production of goods and
services over time.

ANS: F PTS: 1 DIF: 2 REF: 11-0

2. Economists use the term inflation to describe a situation in which the economy’s overall price level
is rising.
 ANS: T PTS: 1 DIF: 1 REF: 11-0

3. The inflation rate is the absolute change in the price level from the previous period.

ANS: F PTS: 1 DIF: 1 REF: 11-0

4. Inflation can be measured using either the GDP deflator or the consumer price index.

ANS: T PTS: 1 DIF: 2 REF: 11-0

5. The CPI is a measure of the overall cost of the goods and services bought by a typical consumer.

ANS: T PTS: 1 DIF: 1 REF: 11-1

6. The content of the basket of goods and services used to compute the CPI changes every month.

ANS: F PTS: 1 DIF: 2 REF: 11-1

7. When the consumer price index is computed, the base year is always the first year among the years
being considered.

ANS: F PTS: 1 DIF: 2 REF: 11-1

8. If the current year CPI is 140, then the price level has increased 40 percent since the base year.

ANS: T PTS: 1 DIF: 2 REF: 11-1

9. The group of goods and services used to compute the GDP deflator changes automatically over
time, but the group of goods and services used to compute the CPI does not.

ANS: T PTS: 1 DIF: 2 REF: 11-1

10. If the consumer price index is 120 in 2009 and 139.2 in 2010, then the rate of inflation for 2010 is
39.2 percent.

ANS: F PTS: 1 DIF: 2 REF: 11-1

11. Consumer price index =  100.

ANS: F PTS: 1 DIF: 1 REF: 11-1

12. When some dollar amount is automatically corrected for inflation by law or contract, the amount is
said to be indexed for inflation.

ANS: T PTS: 1 DIF: 1 REF: 11-2

13. The real interest rate is the interest rate corrected for inflation.

ANS: T PTS: 1 DIF: 1 REF: 11-2

14. The real interest rate tells you how fast the purchasing power of your bank account rises over time.

ANS: T PTS: 1 DIF: 1 REF: 11-2

 15. If the real interest rate is 5 percent and the inflation rate is 2 percent, then the nominal interest rate
is 7 percent.

ANS: T PTS: 1 DIF: 2 REF: 11-2

SHORT ANSWER

1. Which is likely to have the larger effect on the CPI, a 2 percent increase in the price of food or a 3
percent increase in the price of diamond rings? Explain.

ANS:
The 2 percent increase in the price of food will increase the CPI by more because the portion of the
market basket consisting of food is much larger than the portion consisting of diamond rings.

PTS: 1 DIF: 2 REF: 11-1

2. List the three major problems in using the CPI as a measure of the cost of living.

ANS:
(1) Substitution bias. The CPI ignores the fact that consumers substitute toward goods that have
become relatively less expensive. (2) Introduction of new goods. Because the CPI uses a fixed
basket of goods, it does not take into account the increased well-being of consumers created when
new goods are introduced. (3) Unmeasured quality change. Not all quality changes can be
measured.

PTS: 1 DIF: 2 REF: 11-1

3. Why does the GDP deflator give a different rate of inflation than the CPI?

ANS:
The GDP deflator and the CPI differ in two important ways. The GDP deflator uses as a basket
all final goods and services produced in the domestic economy, while the CPI basket includes
goods and services purchased by typical consumers. Therefore, changes in the price of imported
goods affect the CPI, but not the GDP deflator. Also, changes in the price of domestically
produced capital goods affect the GDP deflator, but not the CPI. Changes in the price of
domestically produced consumer goods are likely to affect the CPI more than the GDP deflator
because it is likely that those goods make up a larger part of consumer budgets than of GDP.

PTS: 1 DIF: 2 REF: 11-1

4. Compute how much each of the following items is worth in terms of today's dollars using 177 as
the price index for today.

a. In 1926, the CPI was 17.7 and the price of a movie ticket was $0.25.
b. In 1932, the CPI was 13.1 and a cook earned $15.00 a week.
c. In 1943, the CPI was 17.4 and a gallon of gas cost $0.19.

ANS:

a. The movie ticket is worth $.25 177/17.7 = $2.50 in today's dollars.

b. The cook’s weekly wage is worth $15.00 177/13.1 = $202.67 in today's dollars.
c. The gallon of gas is worth $.19 177/17.4 = $1.93 in today's dollars.
 PTS: 1 DIF: 2 REF: 11-2

5. Jay and Joyce meet George, the banker, to work out the details of a mortgage. They all expect
that inflation will be 2 percent over the term of the loan, and they agree on a nominal interest rate
of 6 percent. As it turns out, the inflation rate is 5 percent over the term of the loan.

a. What was the expected real interest rate?

b. What was the actual real interest rate?
c. Who benefited and who lost because of the unexpected inflation?

ANS:

a. The expected real interest rate was 4 percent (6-2).

b. The actual real interest rate was 1 percent (6-5).
c. George, the banker, lost because he received less real interest income than he expected.
Jay and Joyce gained because they paid less real interest income than they expected.

PTS: 1 DIF: 2 REF: 11-2