Question

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

Inflation in the United States, 1965–2015 Inflation 16% rate (percent) 14 12 10 8 6 4 Кром www 2 0 1965 -2 1975 1985 1995 2005 2015 -4 Copyright © 2018 W. W. Norton & Company, Inc.

(a) From 1965 to 1995, does CPI in the US always increase over time? Explain.

(b) Suppose 2009 is the base year, and the inflation rate between 2009 and 2010 is -2%. (i) What is the CPI in 2009? (ii) Calculate the CPI in 2010. (iii) Between 2009 and 2010, the nominal interest rate is 3%, calculate the real interest rate.

(c) 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.)

(d) 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.

(e) Is it possible that CPI increases but GDP deflator decreases? Explain.

Answer 1

(a). From 1965 to 1995 CPI in the US does not Increases over time. If we start from 1965 and end up in 1995 we can see it has fluctuated over this time period. From 1965 to around 1970 it has increased from below 2% to around 6%. After this it starts to decreases and again it has increased around 12% in 1975. After this it starts to fall and it reaches around 5% in 1977 and then again it starts to increase. This increase and decrease in inflation continues till 1995. That is why it fluctuated over this period of time.

(b). If 2009 is the base year and the inflation rate between 2009 and 2010 is -2% , then

(i) CPI in 2009 is 100% because 2009 is base year and base year price level is always taken as 100.

ii) CPI in 2010 in 98.

Because if inflation is -2% in 2010 then price level has to reduce by 2%. As base level is 100 in 2009 then 2% fall means it has to be 98 in 2010.

iii) Between 2009 and 2010, nominal interest rate is 3%, then real interest rate is nominal interest rate - rate of inflation.

Real interest rate = Nominal interest rate - inflation rate = 3% - (-2%) = 3% + 2% = 5%.(Ans)

(c). During this period firms are unwilling to buy raw materials because the inflation fluctuated over this period. As a result when inflation is at very high cost of inflation will be very high when inflation is very high. The price level increase leads to cost of production increases and that is why firm will not be willing to buy raw materials.

(d). In 1985 CPI is 80 and in 2015 CPI is 188. If $60,000 is earned in 1985 and $119,000 is earned in 2015 then the real income can be calculated as follows-

Real income in 1985 is Nominal income in 1985/Price level in 1985 multiplied by 100.

Real income in 1985 = $(60000/80)*100 = $75,000

Real income in 2015 is Nominal income in 2015 / Price level in 2015 multiplied by 100.

Real income in 2015 = $(119,000/188)*100 = $63,297.87 =$63,298(approx).

Real income in 1985($75,000) is higher than real income in 2015 ($63,298). (Ans)