Question

The following graph shows the inflation rate in the US between 1965 and 2015.

Inflation 16% rate 14 (percent) 12 10 8 6 4 typ harth 2 0 1965 1975 1985 1995 2005 2015 -4

3. Between 1970 and 1985, inflation rate fluctuated severely. Firms might be unwilling to buy raw materials to produce at that time. Explain (This is related to the cost of inflation.)
4. Suppose that CPI in 1985 is 80 and the CPI in 2015 is 188. You earned $60,000 in 1985, and you earned $119,000 in 2015. Do you have a higher real income in 1985 or in 2015? Explain with calculations.
5. Is it possible that CPI increases but GDP deflator decreases? Explain

Answer 1

a. Fluctuations in the inflation rate manifests uncertainty as a cost if inflation. This uncertainty makes firms cautious about real value future prices, wages and profits, as it is largely unknown and highly variable due to rapid fluctuations in inflation and therefore firms are unwilling to invest or take any major production decisions so as to avoid potential future losses.

b. Real Income = (Nominal Income/CPI)*100

In 1985, Real Income =( 60,000/80 )*100 = 75,000

In 2015, Real Income = 1,19,000*100/188 = 63,297.87

Clearly, Real income in 1985 is greater than 2015, due to inflation in year 2015.

c. Yes, it is possible that CPI increases and GDP deflator decreases.

CPI assumes a fixed basket of goods while GDP accounts for a changing basket, moreover CPI is only calculated for goods meant for consumption but GDP deflator is calculated for all goods and services in the economy. Therefore, it is very much possible that price of a consumer good 'X' increases which leads to an increase in CPI, however price of other goods in GDP decreases and thus overshadows the increase in price of 'X, thus in effect decreasing the GDP deflator.

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