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

(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:

A.

CPI has not always increased in the given period, because there are many ups and down in the inflation rate shown by the graph during this period. There is two highest peaks in 1975 and 1980 when inflation rate was highest. It means CPI was also highest during these specific years. But, before and after these peaks, inflation rate has decreased. So, CPI also decreased. Hence, it cannot be said that CPI always increased in the given period.

B.

i.

CPI in 2009 = 100 ( since 2009 is a base year)

ii.

Let, CPI in 2010 = x

Then,

-2% = (x-100)/100

x = -2%*100 + 100

x = 98

CPI in 2010 = 98

iii.

real interest rate (short cut formula) = Nominal interest rate - inflation rate = 3% - (-2%)

real interest rate (short cut formula) = 5%

==

real interest rate (Proper formula) = (1+ Nominal interest rate)/(1+inflation rate) - 1

real interest rate (Proper formula) = (1+3%)/(1-2%) - 1

real interest rate (Proper formula) = 5.1%

C.

There are different types of inflation cost involved, that made firms to hesitate. The first reason is the menu cost that could incur in change in price of the final products frequently. It will cause firms to incur cost in changing the pricing details too frequently. The second reason is the cost push inflation that could rise in cost of production if raw materials are purchased at a higher price, but price of the product does not change. It can create losses to the firm. The third cost of inflation is uncertainty and volatility in the market that can make huge losses to the firms if they buy raw materials at high price and later on, price dropped.

So, above are some of the cost of inflation that led the firms to not to produce in such a scenario.

D.

The income earned in 1985 = $60000

CPI in 1985 = 80

CPI in 2015 = 188

So,

Value of $60000 (earned in 1985) in 2015 = 60000*(188/80)

Value of $60000 (earned in 1985) in 2015 = $141000

But, the actual income earned in 2015 is only $119000 that is less than the equivalent income of $141000, so income earned in 1985 is higher than the income earned in 2015.

E.

It is possible that CPI increases and GDP deflator decreases, because CPI is based on a basket that comprises selected goods and services that are exclusively used by the consumers. Suppose, there is a very poor weather or climate, causing poor production of food crops. It will decrease the supply of essential items and price of commodity products will increase. It will cause CPI to increase.  At the same time, engineering goods price, flight tickets price and other goods not the part of CPI basket, falls sharply due to the superior technology, or other reasons leading to decrease in overall value of GDP deflator. Hence, it is possible that CPI increases while GDP deflator decreases.

PFA