Unit 3: Measuring the Cost of Living
A basket of goods turned into one number, the inflation rate that number implies, and why inflation reshuffles wealth instead of striking everyone equally.
7 topics · 26 questions
Each topic is a path, not a menu: work down it in order and every question builds on the one above. Click any of them to watch the answer draw itself.
Building a Price Index from a Market Basket
- How it worksHow does the cost of a fixed basket in one year get pinned to a base year to create an index number?
- Worked exampleFind the price index in year two when a fixed basket costs 400 dollars in the base year and 460 dollars in year two.
- Common mistakeWhy doesn't a price index reading of 130 mean prices are 130 percent higher than the base year?
Your turn1 of 2
Find the price index in year two when a fixed basket costs 439 dollars in the base year and 545 dollars in year two.Calculating the Inflation Rate
- Worked exampleFind the inflation rate when the price index rises from 210 to 218 over one year.
- How it worksHow does a percentage change between two years of an index number turn into an inflation rate?
- Going furtherWhat does the path of the price level look like during an actual stretch of deflation?
- Common mistakeWhy isn't disinflation the same event as deflation?
Your turn1 of 2
Find the inflation rate when the price index rises from 208 to 248 over one year.Why Price Indexes Overstate True Inflation
- How it worksHow does substitution bias push a fixed-basket index above the inflation people actually experience?
- Common mistakeWhy isn't a laptop that costs the same as last year but runs twice as fast a price change of zero?
- Going furtherWhat happens to a price index the moment a brand new kind of product shows up in stores?
Your turn1 of 2
A fixed basket's measured cost rises 5 percent over a year, but substitution bias inflates that figure by 0.884 percentage points above the true rise in the cost of living. What is the substitution-bias-adjusted inflation rate?Real Versus Nominal Variables
- How it worksHow does dividing a dollar figure by a price index strip inflation out and leave a real value?
- Worked exampleFind the real wage in base-year dollars when the nominal wage is 72000 dollars and the price index reads 120.
- Common mistakeWhy isn't a bigger paycheck automatically more purchasing power?
- Ties togetherHow does the real-versus-nominal split show up again inside an interest rate on a loan?
Your turn1 of 2
Find the real wage, in base-year dollars, when the nominal wage is 77857 dollars and the price index reads 128.Nominal and Real Interest Rates
- How it worksHow does subtracting expected inflation turn a nominal interest rate into a real one?
- Worked exampleFind the real interest rate when the nominal rate is 7 percent and inflation runs at 4.5 percent.
- Common mistakeWhy isn't the interest rate printed on a loan contract the rate a lender actually ends up earning?
- Going furtherWhat happens to the real interest rate on old loans once inflation unexpectedly turns negative?
Your turn1 of 2
Find the real interest rate when the nominal rate is 8 percent and inflation runs at 5 percent.Who Inflation Hits and Who It Spares
- Worked exampleFind who gains when a 5 percent fixed-rate loan is signed expecting 2 percent inflation and 6 percent inflation shows up instead.
- How it worksWalk me through what an unexpected burst of inflation does to a bank holding thousands of fixed-rate mortgages.
- Common mistakeWhy doesn't inflation make every single person in an economy poorer at the same time?
- Going furtherWhat happens to a retiree living on a fixed pension when inflation runs at 9 percent for three straight years?
Your turn1 of 2
A borrower signs a 6 percent fixed-rate loan when 2 percent inflation was expected, but actual inflation turns out to be 9 percent. By how many percentage points did the real interest rate the borrower ends up paying fall, compared to what was expected?The Real Costs of Inflation
- How it worksHow do menu costs and shoe-leather costs eat up resources that produce nothing extra for anyone?
- Going furtherWhat happens to menu costs and shoe-leather costs once inflation runs at 50 percent a month?
- Common mistakeWhy isn't the main cost of a fully anticipated, stable inflation the fact that prices went up?
- Ties togetherHow does indexing wages and tax brackets to inflation shrink the very costs this topic describes?
Your turn1 of 2
A business in a high-inflation country has to reprint its menus and price lists every single week just to keep up with rising prices, and customers spend extra time comparing prices and running to the bank more often. What are these two costs called?