Exercise 1: Price Indexes

In Fast Foodland the market basket of goods is 2 hotdogs and 1 cheeseburger. Fill in the
table below, using 2019 as the base year.

year hotdogs cheeseburgers CPI GDP

price quantity price quantity nominal real deflator
2017 $2 400 $3.50 200
2018 $2.50 300 $3 250
2019 $3 310 $4 150

Using the information above, calculate the rate of change in prices of hotdogs and cheeseburgers, the
inflation rate, and the growth rate of nominal and real GDP from 2017 to 2018and 2018 to 2019. Is
there anything that is counter intuitive?

Year Hotdog prices Cheeseburger CPI Nominal Real GDP

prices GDP
2017/2018
2018/2019

Exercise 2. CPI.
Table 2 lists the average prices faced by consumers (from 1980-2000) across five categories of
household expenditure: housing, clothing, fuel, food, and entertainment.
Table 2: Average Prices
year housing clothing fuel food entertainment
2000 $100000 $25 $2.50 $4 $5
2010 $150000 $50 $3 $5 $10
2020 $125000 $50 $4 $8 $20

When calculating market basket expenditure, the Bureau of Labor Statistics wants you to use the following weights
(fixed quantities) for each category of expenditure. These weights represent the portion of consumer spending on each
of the categories. (For example, fuel price is per/gallon, but consumers don’t just buy 1 gallon. They do, however,
typically only buy 1 house, so the weights on prices must be different.) Assume that the weights do not change over
time. Given market basket expenditure in each year, you can compute the Consumer Price Index (CPI).

category weight
Housing 0.02
clothing 0.10
Fuel 0.20
Food 0.50
Entertainment 0.18

Even though Housing is very expensive, it only has a 2% weight on the CPI in this example.
This means the market basket would be $100,000*0.02 + …etc. for the year 2000. (it is okay to
use a calculator for the following questions)
 a) Calculate the market basket expenditures for each year: 1990, 2000, 2010.

b) Calculate the CPI on a one hundred point scale for each year using 2000 as the base year.

c) Calculate the CPI on a one hundred point scale for each year using 2020 as the base year.

d) Compute the CPI growth rate from 2000-2010 and 2010-2020. What do these growth rates mean?

Exercise 3. Quantity theory of money

Suppose real GDP is growing 3 percent, the money supply is growing at 10 percent, the
velocity of money is constant, and the real interest rate is 5 percent.

a. What is the current inflation rate and nominal interest rate?

b. If the money supply growth rate increases to 15 percent, how will your answers in part
(a) change?

c. If you were an investor, how would the change in the money supply growth affect your real
profitability, assuming that you now receive the new nominal interest rate?

d. Based on your previous answers, would you prefer a fixed or a floating interest rate on your
investments? Which would you prefer if you thought the money supply growth was going to
be reduced?

Discussion exercise 4
During World War II, both Germany and England had plans for a paper weapon: they each
printed the other’s currency, with the intention of dropping large quantities by airplane. Why
might this have been an effective weapon?

Exercise 5:
In each of the following scenarios, explain and categorize the cost of inflation.
a. Because inflation has risen, the L.L. Bean Company decides to issue a new catalog quarterly
rather than annually.
b. Grandma buys an annuity for $100,000 from an insurance company, which promises to pay
her $10,000 a year for the rest of her life. After buying it, she is surprised that high inflation
triples the price level over the next few years.
c. Maria lives in an economy with hyperinflation. Each day after being paid, she runs to the store as
quickly as possible so she can spend her money before it loses value.
d. Warren lives in an economy with an infl ation rate of 10 percent. Over the past year, he earned
a return of $50,000 on his million dollar portfolio of stocks and bonds. Because his tax rate is 20
percent, he paid $10,000 to
the government.
e. Your father tells you that when he was your age, he worked for only $3 an hour. He suggests
that you are lucky to have a job that pays $7 an hour.
Question 6
Some economic historians have noted that during the period of the gold standard, gold
discoveries were most likely to occur after a long deflation. (The discoveries of 1896 are an
example.) Why might this be true?