HE5091 Principles of Economics Lecture 7 Quiz
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Questions and Answers

Which of the following statements about inflation is true?

  • Inflation distorts the tax incentives for work, saving, and investing. (correct)
  • Inflation does not affect the purchasing power of cash over time.
  • Inflation has no real costs associated with it.
  • Higher inflation leads to higher economic growth.

    • What are the 'shoe leather' costs associated with inflation?

  • The time and travel costs incurred by consumers and businesses for more frequent, smaller cash withdrawals. (correct)
  • The cost of banks processing more transactions due to more frequent withdrawals.
  • The cost of unexpected wealth redistribution from lenders to borrowers.
  • The cost of frequently updating price lists (menus).

    • What is the 'menu cost' associated with inflation?

  • The cost of unexpected wealth redistribution from lenders to borrowers.
  • The cost of banks processing more transactions due to more frequent withdrawals.
  • The time and travel costs incurred by consumers and businesses for more frequent, smaller cash withdrawals.
  • The resources consumed by sellers in frequently updating their price lists. (correct)

    • How does unexpected inflation affect the distribution of wealth?

    <p>It redistributes wealth from workers to employers and from lenders to borrowers.</p> Signup and view all the answers

    What is the real interest rate?

    <p>The nominal interest rate minus the inflation rate.</p> Signup and view all the answers

    What is the Fisher effect?

    <p>The tendency for nominal interest rates to be high when inflation is high and low when inflation is low.</p> Signup and view all the answers

    Which of the following statements about inflation-protected bonds is true?

    <p>They pay a real interest rate plus the inflation rate.</p> Signup and view all the answers

    What was the highest real interest rate observed in the data provided?

    <p>7.0% in 1985</p> Signup and view all the answers

    In which year was the nominal interest rate the highest according to the data?

    <p>1980</p> Signup and view all the answers

    According to the data, in which year was the difference between the nominal interest rate and the inflation rate the smallest?

    <p>1980</p> Signup and view all the answers

    Study Notes

    Measuring Economic Output

    • Gross Domestic Product (GDP): the market value of final goods and services produced in a country in a given period of time
    • Components of GDP: consumer goods and services, investment, government purchases, and net exports

    Final Goods and Services

    • Final goods: consumed by the ultimate user, e.g. a haircut
    • Intermediate goods: used up in the production of final goods, e.g. flour for baking bread
    • Value Added: the market value of a product minus the cost of inputs purchased from other firms

    Expenditure Method

    • Users of final goods: households, government, firms, and foreigners
    • GDP can be measured by: the total spending for final goods and services less the value of imports
    • Expenditure categories: consumption, investment, government purchases, and net exports

    Income Approach

    • GDP can be calculated by: the sum of labor income and capital income
    • Labor income: wages, salaries, benefits, and incomes of the self-employed
    • Capital income: profits, interest, rent, and royalties

    Adjusting for Price Changes

    • Nominal GDP: values output in the current year using current prices
    • Real GDP: values output in the current year using base year prices
    • Real GDP measures: the physical volume of output

    Real and Nominal GDP

    • Nominal GDP will exceed real GDP: when prices are increasing (inflation)
    • Nominal GDP will be smaller than real GDP: when prices are decreasing (deflation)

    Real GDP and Economic Well-being

    • Real GDP is a flawed measure of well-being: it values only market transactions and omits nonmarket economic activities
    • GDP does not account for: intangibles like crime rates, traffic congestion, and open space

    Nonmarket Economic Activities

    • Examples of nonmarket activities: household production, volunteer services, and illegal activities
    • These activities are important: especially in poor countries where they are a significant part of economic activity

    Underground Economy

    • Unreported transactions: legal and illegal, e.g. casual labor, baby-sitting, home repair
    • Estimates suggest the underground economy is large: regardless of national income level

    Environmental Quality

    • Production of more output: requires more factories, extraction of mineral resources, and contributes to environmental degradation
    • Depletion of resources: may damage the environment permanently

    Inflation

    • Price level: the average price of a given class of goods and services relative to the price of the same goods and services in a base year
    • Consumer Price Index (CPI): a measure of the cost of living during a particular period
    • Rate of inflation: the annual percentage change in the price level

    Adjusting for Inflation

    • Nominal quantity: measured in terms of its current dollar value
    • Real quantity: measured in physical terms
    • Deflating a nominal quantity: converts it to a real quantity by dividing by the price index

    Real Wages

    • Real wage: the wage paid to the worker measured in terms of purchasing power
    • Real wage is calculated by: dividing the nominal wage by the CPI

    Indexing

    • Indexing: increases a nominal quantity each period by the percentage increase in a specified price index
    • Indexing prevents the purchasing power: of the nominal quantity from being eroded by inflation

    The Costs of Inflation

    • Prices transmit information: about the cost of production and the value buyers place on buying an additional unit

    • Inflation creates static: in the communication between buyers and sellers, making it difficult to distinguish between relative price changes and inflation

    • Indexing avoids distortions: by matching tax rates to the real income level### Inflation and Economic Growth

    • High inflation rates lead to lower savings and investment, resulting in lower economic growth.

    • Non-indexed taxes distort tax incentives for work, save, and invest, further hindering economic growth.

    Shoe Leather and Menu Cost

    • High inflation causes cash to lose value over time, prompting consumers and businesses to manage cash balances to limit losses.
    • Frequent, smaller withdrawals increase costs for consumers and businesses, including "shoe leather" costs and bank processing fees.
    • Sellers must frequently adjust price lists (menu cost) to account for inflation, consuming resources.

    Unexpected Redistribution of Wealth

    • Unexpected inflation redistributes wealth, benefiting borrowers at the expense of lenders when salaries and interest rates are not indexed.
    • Employers gain at the expense of workers when salaries are not indexed and inflation is higher than anticipated.

    Interference with Long-Term Planning

    • Erratic inflation makes long-term planning risky, as unexpected changes in purchasing power can affect retirement planning and lived standards.

    Inflation and Interest Rates

    • Unanticipated inflation helps borrowers and hurts lenders, as real interest rates are affected by inflation.
    • The real interest rate is the nominal interest rate minus inflation (r = i - p).
    • Nominal interest rates vary with inflation, ranging from 3.2% to 11.4%, while inflation rates range from 1.6% to 13.5%.

    Historical Inflation and Interest Rates

    • The real interest rate was highest in 1985 (7.0%) and lowest in 1980 (-2.1%).
    • Nominal interest rates and inflation rates have varied over the years, with a general trend of decreasing rates since the 1980s.

    Fisher Effect and Inflation-Protected Bonds

    • The Fisher effect describes the tendency for nominal interest rates to be high when inflation is high and low when inflation is low.
    • Inflation-protected bonds pay a real rate of interest plus the inflation rate, protecting lenders from unexpected inflation.

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    Description

    Test your understanding of Gross Domestic Product (GDP), inflation, the Consumer Price Index, and other macroeconomic concepts covered in Lecture 7 of HE5091 Principles of Economics. Topics include the Expenditure Method, Nominal and Real GDP, Real GDP's impact on economic well-being, and adjusting for inflation costs.

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