I want the answers for these questions but with the detail answers

I want the answers for these questions but with the detail answers
THINGS TO KNOW FOR TERM EXAM #2 1. Chapter 5 What is GDP, real GDP, nominal GDP? Different ways to calculate GDP What is the CPI and GDP deflator? (differences/similarities) What are the growth rate, GDP deflator, gross investment, net exports, national income formulas? Economic goals, growth rate benchmarks, omissions from GDP/well being measure What is personal income, personal disposable income, savings, how calculated 2. Chapter 6 What is the CPI, what calculated, what does it measure, problems with CPI with the way it is calculated Uses of the CPI measure How to correct economic variables for effects of inflation Real and nominal interest rates 3. Chapter 7 Why discrepancy in economic growth rates between nations (rich and poor) What is standard of living, productivity? How productivity calculated, determinants of productivity? Relationship between savings, investment, productivity Government policies to change productivity Factors affecting productivity, production function
I want the answers for these questions but with the detail answers
Chapter 5 Measuring a Nation’s Income SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1. What two things does gross domestic product measure? How can it measure two things at once? Gross domestic product measures two things: (1) the total income of everyone in the economy; and (2) the total expenditure on the economy’s output of goods and services. It can measure both of these things at once because income must equal expenditure for the economy as a whole. 2. Which contributes more to GDP—the production of a kilogram of hamburger or the production of a kilogram of caviar? Why? The production of a kilogram of caviar contributes more to GDP than the production of a kilogram of hamburger because the contribution to GDP is measured by market value and the price of a kilogram of caviar is much higher than the price of a kilogram of hamburger. 3. List the four components of expenditure. • What does it mean when net exports have a negative value? The four components of expenditure are: (1) consumption; (2) investment; (3) government purchases; and (4) net exports. Net exports are equal to the difference between the value of exports and the value of imports. When our country imports more than it exports, net exports are negative. 4. Define real and nominal GDP. Which is a better measure of economic well-being? Why? Nominal GDP is the production of goods and services valued at current prices. Real GDP is the production of goods and services valued at constant prices. Real GDP is a better measure of economic well-being because it reflects the economy’s ability to satisfy people’s needs and desires. Thus, a rise in real GDP means people have produced more goods and services, but a rise in nominal GDP could occur either because of increased production and/or because of higher prices. 5. Why should policymakers care about GDP? Although GDP is not a perfect measure of economic well-being, policymakers should care about it because a larger GDP means that a nation can afford better health care, better educational systems, and more of the material necessities of life. Questions for Review 1. Explain why an economy’s income must equal its expenditure. An economy’s income must equal its expenditure since every transaction has a buyer and a seller. Thus, expenditure by buyers must equal income of sellers. 2. Which contributes more to GDP—the production of an economy car or the production of a luxury car? Why? The production of a luxury car contributes more to GDP than the production of an economy car because the luxury car has a higher market value. 3. A farmer sells wheat to a baker for $2. The baker uses the wheat to make bread, which is sold for $3. What is the total contribution of these transactions to GDP? The contribution to GDP is $3, the market value of the bread, which is the final good that is sold. 4. Many years ago Peggy paid $500 to put together a record collection. Today she sold her albums at a garage sale for $100. How does this sale affect current GDP? The sale of used records does not affect GDP at all because it involves no current production. 5. List the four components of GDP. Give an example of each. The four components of GDP are consumption, such as the purchase of a music CD; investment, such as the purchase of a computer by a business; government purchases, such as an order for military aircraft; and net exports, such as the sale of Canadian wheat to Russia. 6. Why do economists use real GDP rather than nominal GDP to gauge economic well-being? Economists use real GDP rather than nominal GDP to gauge economic well-being because real GDP is not affected by changes in prices, so it reflects only changes in the amounts being produced. If nominal GDP rises, you do not know if that is because of increased production and/or higher prices. 7. In the year 2014, the economy produces 100 loaves of bread that sell for $2 each. In the year 2015, the economy produces 200 loaves of bread that sell for $3 each. Calculate nominal GDP, real GDP, and the GDP deflator for each year. (Use 2014 as the base year.) By what percentage does each of these three statistics rise from one year to the next? Year Nominal GDP Real GDP GDP Deflator 2014 100 × $2 = $200 100 × $2 = $200 ($200/$200) × 100 = 100 2015 200 × $3 = $600 200 × $2 = $400 ($600/$400) × 100 = 150 The percentage change in nominal GDP is (600 – 200)/200 × 100 = 200%. The percentage change in real GDP is (400 – 200)/200 × 100 = 100%. The percentage change in the deflator is (150 – 100)/100 × 100 = 50%. 8. Why is it desirable for a country to have a large GDP? Give an example of something that would raise GDP and yet be undesirable. It is desirable for a country to have a large GDP because people could enjoy more goods and services. But GDP is not the only important measure of economic well-being. For example, laws that restrict pollution cause GDP to be lower. If laws against pollution were eliminated, GDP would be higher, but the pollution might make us worse off. Or, for example, an earthquake would raise GDP, as expenditures on cleanup, repair, and rebuilding increase. But an earthquake is an undesirable event that lowers our welfare. Quick Check Multiple Choice 1. If the price of a hot dog is $2 and the price of a hamburger is $4, then 30 hot dogs contribute as much to GDP as what number of hamburgers? a. 5 b. 15 c. 30 d. 60 2. Angus the sheep farmer sells wool to Barnaby the knitter for $20. Barnaby makes two sweaters, each of which has a market price of $40. Collette buys one of them, while the other remains on the shelf of Barnaby’s store to be sold later. What is GDP here? a. $40 b. $60 c. $80 d. $100 3. Which of the following does NOT add to Canada’s GDP? a. Air France buys a plane from Bombardier, the Canadian aircraft manufacturer. b. PotashCorp develops a new mine in Saskatchewan. c. The city of Toronto pays a salary to a police officer. d. The federal government sends a Canada Pension Plan cheque to your grandmother. 4. A Canadian buys a pair of shoes manufactured in Italy. How is the transaction treated in Canada’s national income accounts? a. net exports and GDP both rise b. net exports and GDP both fall c. net exports fall, while GDP is unchanged d. net exports are unchanged, while GDP rises 5. What is the largest component of GDP? a. consumption b. investment c. government purchases d. net exports 6. If all quantities produced rise by 10 percent and all prices fall by 10 percent, which of the following occurs? a. Real GDP rises by 10 percent, while nominal GDP falls by 10 percent. b. Real GDP rises by 10 percent, while nominal GDP is unchanged. c. Real GDP is unchanged, while nominal GDP rises by 10 percent. d. Real GDP is unchanged, while nominal GDP falls by 10 percent. 1. b 2. c 3. d 4. c 5. a 6. b Problems and Applications 1. What components of GDP (if any) would each of the following transactions affect? Explain. a. A family buys a new refrigerator. b. Aunt Jane buys a new house. c. Ford sells a Thunderbird from its inventory. d. You buy a pizza. e. Quebec repaves Highway 50. f. Your parents buy a bottle of French wine. g. Honda expands its factory in Alliston, Ontario. a. Consumption increases because a refrigerator is a good purchased by a household. Investment increases because a house is an investment good. Consumption increases because a car is a good purchased by a household, but investment decreases because the car in Ford’s inventory had been counted as an investment good until it was sold. Consumption increases because pizza is a good purchased by a household. Government purchases increase because the government spent money to provide a good to the public. Consumption increases because the bottle is a good purchased by a household, but net exports decrease because the bottle was imported. Investment increases because new structures and equipment were built. 2. The “government purchases” component of GDP does not include spending on transfer payments such as Employment Insurance. Thinking about the definition of GDP, explain why transfer payments are excluded. With transfer payments, nothing is produced, so there is no contribution to GDP. 3. Why do you think households’ purchases of new housing are included in the investment component of GDP rather than the consumption component? Can you think of a reason why households’ purchases of new cars should also be included in investment rather than in consumption? To what other consumption goods might this logic apply? Purchases of new housing are included in the investment portion of GDP because housing provides services for a long time. For the same reason, purchases of new cars could be thought of as investment, but by convention they are not. The logic could apply to any durable good, such as household appliances. 4. As the chapter states, GDP does not include the value of used goods that are resold. Why would including such transactions make GDP a less informative measure of economic well-being? If GDP included goods that are resold, it would be counting output of that particular year, plus sales of goods produced in a previous year. It would double-count goods that were sold more than once and would count goods in GDP for several years if they were produced in one year and resold in another. 5. Below are some data from the land of milk and honey. Year Price of Milk Quantity of Milk (litres) Price of Honey Quantity of Honey (litres) 2013 $1 100 $2 50 2014 1 200 2 100 2015 2 200 4 100 a. Compute nominal GDP, real GDP, and the GDP deflator for each year, using 2013 as the base year. b. Compute the percentage change in nominal GDP, real GDP, and the GDP deflator in 2014 and 2015 from the preceding year. For each year, identify the variable that does not change. Explain in words why your answer makes sense. c. Did economic well-being rise more in 2014 or 2015? Explain. a. Calculating nominal GDP: 2013: ($1 per L of milk  100 L milk) + ($2 per L of honey  50 L honey) = $200 2014: ($1 per L of milk  200 L milk) + ($2 per L of honey  100 L honey) = $400 2015: ($2 per L of milk  200 L milk) + ($4 per L of honey  100 L honey) = $800 Calculating real GDP (base year 2008): 2013: ($1 per L of milk  100 L milk) + ($2 per L of honey  50 L honey) = $200 2014: ($1 per L of milk  200 L milk) + ($2 per L of honey  100 L honey) = $400 2015: ($1 per L of milk  200 L milk) + ($2 per L of honey  100 L honey) = $400 Calculating the GDP deflator: 2013: ($200/$200)  100 = 100 2014: ($400/$400)  100 = 100 2015: ($800/$400)  100 = 200 b. Calculating the percentage change in nominal GDP: Percentage change in nominal GDP in 2014 = [($400 – $200)/$200]  100 = 100%. Percentage change in nominal GDP in 2015 = [($800 – $400)/$400]  100 = 100%. Calculating the percentage change in real GDP: Percentage change in real GDP in 2014 = [($400 – $200)/$200]  100 = 100%. Percentage change in real GDP in 2015 = [($400 – $400)/$400]  100 = 0%. Calculating the percentage change in GDP deflator: Percentage change in the GDP deflator in 2014 = [(100 – 100)/100]  100 = 0%. Percentage change in the GDP deflator in 2015 = [(200 – 100)/100]  100 = 100%. Prices did not change from 2013 to 2014. Thus, the percentage change in the GDP deflator is zero. Likewise, output levels did not change from 2014 to 2015. This means that the percentage change in real GDP is zero. c. Economic well-being rose more in 2014 than in 2015, since real GDP rose in 2014 but not in 2015. In 2014, real GDP rose and prices didn’t. In 2015, real GDP didn’t rise and prices did. 6. Consider an economy that produces only chocolate bars. In year 1, the quantity produced is 3 bars and the price is $4. In year 2, the quantity produced is 4 bars and the price is $5. In year 3, the quantity produced is 5 bars and the price is $6. Year 1 is the base year. a. What is nominal GDP for each of these three years? b. What is real GDP for each of these years? c. What is the GDP deflator for each of these years? d. What is the percentage growth rate of real GDP from year 2 to year 3? e. What is the inflation rate as measured by the GDP deflator from year 2 to year 3? f. In this one-good economy, how might you have answered parts (d) and (e) without first answering parts (b) and (c)? a. Calculating Nominal GDP: Year 1: (3 bars  $4) = $12 Year 2: (4 bars  $5) = $20 Year 3: (5 bars  $6) = $30 b. Calculating Real GDP: Year 1: (3 bars  $4) = $12 Year 2: (4 bars  $4) = $16 Year 3: (5 bars  $4) = $20 c. Calculating the GDP deflator: Year 1: $12/$12  100 = 100 Year 2: $20/$16  100 = 125 Year 3: $30/$20  100 = 150 d. The growth rate of real GDP from Year 2 to Year 3 = (20 – 16)/16  100 = 25% e. The inflation rate from Year 2 to Year 3 = (150 – 125)/125  100 = 20% f. To calculate the growth rate of real GDP, we could simply calculate the percentage change in the quantity of bars. To calculate the inflation rate, we could measure the percentage change in the price of bars. 7. Consider the following data on Canadian GDP: Year Nominal GDP (billions) GDP Deflator (base year 2007) 2013 $1893 111 2014 $1975 113 a. What was the growth rate of nominal GDP between 2013 and 2014? (Note: The growth rate is the percentage change from one period to the next.) b. What was the growth rate of the GDP deflator between 2013 and 2014? c. What was real GDP in 2013 measured in 2007 prices? d. What was real GDP in 2014 measured in 2007 prices? e. What was the growth rate of real GDP between 2013 and 2014? f. Was the growth rate of nominal GDP higher or lower than the growth rate of real GDP? Explain. a. The growth rate of nominal GDP between 2013 and 2014 is ($1975 – $1893)/$1893  100% = 4.3%. b. The growth rate of the deflator is (113 – 111)/111  100% = 1.8%. c. Real GDP in 2013 (in 2007 dollars) is $1893/(111/100) = $1,705. d. Real GDP in 2014 (in 2007 dollars) is $1975/(113/100) = $1,748. e. The growth rate of real GDP is ($1748 – $1705)/$1705  100% = 2.5%. f. The growth rate of nominal GDP is greater than the growth rate of real GDP because the inflation rate was positive. 8. If prices rise, people’s income from selling goods increases. The growth of real GDP ignores this gain, however. Why, then, do economists prefer real GDP as a measure of economic well-being? Economists ignore the rise in people’s incomes that is caused by higher prices because although incomes are higher, the prices of the goods and services that people buy are also higher. Therefore, they will not necessarily be able to purchase more goods and services. For this reason, economists prefer to look at real GDP instead of nominal GDP. 9. Revised estimates of Canadian GDP are usually released by Statistics Canada near the end of each month. Find a newspaper article that reports on the most recent release, or read the news release yourself at www.statcan.gc.ca, the website of Statistics Canada. Discuss the recent changes in real and nominal GDP and in the components of GDP. Many answers are possible. 10. Goods and services that are not sold in markets, such as food produced and consumed at home, are generally not included in GDP. Can you think of how this might cause the numbers in the second column of Table 5.4 to be misleading in a comparison of the economic well-being of Canada and India? Explain. In countries like India, people produce and consume a fair amount of food at home that is not included in GDP. So GDP per person in India and Canada will differ by more than their comparative economic well-being. 11. The participation of women in the Canadian labour force has risen dramatically since 1970. a. How do you think this rise affected GDP? b. Now imagine a measure of well-being that includes time spent working in the home and taking leisure time. How would the change in this measure of well-being compare to the change in GDP? c. Can you think of other aspects of well-being that are associated with the rise in women’s labour-force participation? Would it be practical to construct a measure of well-being that includes these aspects? a. The increased labour-force participation of women has increased GDP in Canada, since it means more people are working and production has increased. b. If our measure of well-being included time spent working in the home and taking leisure, it wouldn’t rise as much as GDP, since the rise in women’s labour-force participation has reduced time spent working in the home and taking leisure. c. Other aspects of well-being that are associated with the rise in women’s increased labour-force participation include increased self-esteem and prestige for women in the workforce, especially at managerial levels, but decreased quality time spent with children, whose parents have less time to spend with them. Such aspects would be quite difficult to measure. Copyright © 2017 Nelson Education Ltd.
I want the answers for these questions but with the detail answers
Chapter 6 Measuring the Cost of Living SOLUTIONS TO TEXTBOOK PROBLEMS Quick Quizzes 1. Explain briefly what the consumer price index is trying to measure and how it is constructed. The consumer price index tries to measure the overall cost of the goods and services bought by a typical consumer. It is constructed by surveying consumers to fix a basket of goods and services that the typical consumer buys, finding the prices of the goods and services over time, computing the cost of the basket at different times, and then choosing a base year. To compute the price index, we divide the cost of the market basket in the current year by the cost of the market basket in the base year and multiply by 100. 2. Henry Ford paid his workers $5 a day in 1914. If the U.S. consumer price index was 10 in 1914 and 195 in 2005, how much is the Ford daily paycheque worth in 2005 dollars? Since Henry Ford paid his workers $5 a day in 1914 and the consumer price index was 10 in 1914 and 195 in 2005, then the Ford daily paycheque was worth $5  195/10 = $97.50 a day in 2005 dollars. Questions for Review 1. Which do you think has a greater effect on the consumer price index: a 10 percent increase in the price of chicken or a 10 percent increase in the price of caviar? Why? A 10 percent increase in the price of chicken has a greater effect on the consumer price index than a 10 percent increase in the price of caviar because chicken is a bigger part of the average consumer’s market basket. 2. Describe the three problems that make the consumer price index an imperfect measure of the cost of living. The three problems in the consumer price index as a measure of the cost of living are: (1) substitution bias, which arises because people substitute toward goods that have become relatively less expensive; (2) the introduction of new goods, which are not reflected quickly in the CPI; and (3) unmeasured quality change. 3. If the price of a military aircraft rises, is the consumer price index or the GDP deflator affected more? Why? If the price of a military aircraft rises there is no effect on the consumer price index, since military aircraft are not consumer goods. But the GDP deflator is affected, since military aircraft are included in GDP as a part of government purchases. 4. Over a long period of time, the price of a candy bar rose from $0.10 to $0.60. Over the same period, the consumer price index rose from 150 to 300. Adjusted for overall inflation, how much did the price of the candy bar change? Since the overall price level doubled, but the price of the candy bar rose sixfold, the real price (the price adjusted for inflation) of the candy bar tripled. 5. Explain the meaning of nominal interest rate and real interest rate. How are they related? The nominal interest rate is the rate of interest paid on a loan in dollar terms. The real interest rate is the rate of interest corrected for inflation. The real interest rate is the nominal interest rate minus the rate of inflation. Quick Check Multiple Choice 1. The consumer price index measures approximately the same economic phenomenon as which of the following? a. nominal GDP b. real GDP c. the GDP deflator d. the unemployment rate 2. What is the largest component in the basket of goods and services used to compute the CPI? a. food and beverages b. housing c. transportation d. apparel 3. If a Manitoba gun manufacturer raises the price of rifles it sells to the Canadian Army, which of the following will be increased by the price hikes? a. both the CPI and the GDP deflator b. neither the CPI nor the GDP deflator c. the CPI but not the GDP deflator d. the GDP deflator but not the CPI 4. Which of the following occurs because consumers can sometimes substitute cheaper goods for those that have risen in price? a. the CPI overstates inflation b. the CPI understates inflation c. the GDP deflator overstates inflation d. the GDP deflator understates inflation 5. If the consumer price index was 200 in 1980 and 300 today, then $600 in 1980 has the same purchasing power as what amount today? a. $400 b. $500 c. $700 d. $900 6. You deposit $2000 in a savings account, and a year later you have $2100. Meanwhile, the consumer price index rises from 200 to 204. In this case, what are the nominal interest rate and the real interest rate, respectively? a. 1 percent; 5 percent b. 3 percent; 5 percent c. 5 percent; 1 percent d. 5 percent; 3 percent 1. c 2. b 3. d 4. a 5. d 6. d Problems and Applications 1. Suppose that people consume only three goods, as shown in this table: Tennis Balls Tennis Racquets Gatorade 2014 price 2014 quantity $2 100 $40 10 $1 200 2015 price 2015 quantity $2 100 $60 10 $2 200 a. What is the percentage change in the price of each of the three goods? What is the percentage change in the overall price level? b. Do tennis racquets become more or less expensive relative to Gatorade? Does the well-being of some people change relative to the well-being of others? Explain. a. The price of tennis balls increases 0 percent; the price of tennis racquets increases 50 percent [= ($60 – $40)/$40 × 100%]; the price of Gatorade increases 100 percent [= ($2 – $1)/$1 × 100%]. To find the percentage change in the overall price level, follow these steps: 1) Determine the fixed basket of goods: 100 balls, 10 racquets, 200 Gatorades 2) Find the price of each good in each year: Year Balls Racquets Gatorade 2014 $2 $40 $1 2015 $2 $60 $2 3) Compute the cost of the basket of goods in each year: 2014: (100 × $2) + (10 × $40) + (200 × $1) = $800 2015: (100 × $2) + (10 × $60) + (200 × $2) = $1200 4) Choose one year as a base year (2014) and compute the CPI in each year: 2014: $800/$800 × 100 = 100 2015: $1200/$800 × 100 = 150 5) Use the CPI to compute the inflation rate from the previous year: 2015: (150 – 100)/100 × 100% = 50% b. Tennis racquets are less expensive relative to Gatorade, since their price rose 50 percent while the price of Gatorade rose 100 percent. The well-being of some people changes relative to the well-being of others. Those who purchase a lot of Gatorade become worse off relative to those who purchase a lot of tennis racquets or tennis balls. 2. Suppose that the residents of Vegopia spend all of their income on cauliflower, broccoli, and carrots. In 2014 they buy 100 heads of cauliflower for $200, 50 bunches of broccoli for $75, and 500 carrots for $50. In 2015 they buy 75 heads of cauliflower for $225, 80 bunches of broccoli for $120, and 500 carrots for $100. If the base year is 2014, what is the CPI in both years? What is the inflation rate in 2015? To find the percentage change in the overall price level, follow these steps: 1) Determine the fixed basket of goods: 100 heads of cauliflower, 50 bunches of broccoli, 500 carrots. 2) Find the price of each good in each year: Year Cauliflower Broccoli Carrots 2014 $2 $1.50 $0.10 2015 $3 $1.50 $0.20 3) Compute the cost of the basket of goods in each year: 2014: (100 × $2) + (50 × $1.50) + (500 × $.10) = $325 2015: (100 × $3) + (50 × $1.50) + (500 × $.20) = $475 4) Choose one year as a base year (2014) and compute the CPI in each year: 2014: $325/$325 × 100 = 100 2015: $475/$325 × 100 = 146 5) Use the CPI to compute the inflation rate from the previous year: 2015: (146 – 100)/100 × 100% = 46% 3. Go to the website of Statistics Canada (www.statcan.gc.ca) and find data on the consumer price index. By how much has the index including all items risen over the past year? For which categories of spending have prices risen the most? The least? Have any categories experienced price declines? Can you explain any of these facts? Many answers are possible. 4. A small nation of ten people idolizes the TV show Canadian Idol. All that the ten people produce and consume are karaoke machines and CDs, in the following amounts: Karaoke Machines CDs Quantity Price Quantity Price 2014 10 $40 30 $10 2015 12 60 50 12 a. Using a method similar to the consumer price index, compute the percentage change in the overall price level. Use 2014 as the base year, and fix the basket at 1 karaoke machine and 3 CDs. b. Using a method similar to the GDP deflator, compute the percentage change of the overall price level. Also use 2014 as the base year. c. Is the inflation rate in 2015 the same using the two methods? Explain why or why not. a. The expenditures on the consumption basket in the two years are: 2014: Expenditure = 1 × $40 + 3 × $10 = $70; CPI = 100 2015: Expenditure = 1 × $60 + 3 × $12 = $96; CPI = 96/70 × 100 = 137.1 The inflation rate is 37.1 percent. b. 2014: GDP = 10 × $40 + 30 × $10 = $700; GDP deflator = 100 2015: Nominal GDP = 12 × $60 + 50 × $12 = $1320; Real GDP = 12 × $40 + 50 × $10 = $980; GDP deflator = 1320/980 × 100 = 134.69 Inflation rate = 34.69 percent. c. The inflation rates calculated in the two different ways are different because one is based on a consumption basket, while the other is on the GDP deflator. The weights in which each price enters the two price indexes (CPI and GDP deflator) are different. 5. Which of the problems in the construction of the CPI might be illustrated by each of the following situations? Explain. a. The invention of the iPad b. The introduction of air bags in cars c. Increased personal computer purchases in response to a decline in the price d. More scoops of raisins in each package of Raisin Bran e. Greater use of fuel-efficient cars after gasoline prices increase introduction of new goods unmeasured quality change substitution bias unmeasured quality change substitution bias 6. A single copy of the Ottawa Citizen cost $0.10 in 1970 and $0.50 in 1990. The average wage in manufacturing was $3.01 per hour in 1970 and $14.19 in 1990. a. By what percentage did the price of a newspaper rise? b. By what percentage did the wage rise? c. In each year, how many minutes does a worker have to work to earn enough to buy a newspaper? d. Did workers’ purchasing power in terms of newspapers rise or fall? a. ($0.50 – $0.10)/$0.10 × 100% = 400%. b. ($14.19 – $3.01)/$3.01 × 100% = 371%. c. In 1970: $0.10/($3.01/60) = 2.0 minutes. In 1990: $0.50/($14.19/60) = 2.1 minutes. d. Workers’ purchasing power fell in terms of newspapers. 7. The chapter explains that Canada Pension Plan benefits are increased each year in proportion to the increase in the CPI, even though most economists believe that the CPI overstates actual inflation. a. If the elderly consume the same market basket as other people, does the Canada Pension Plan provide the elderly with an improvement in their standard of living each year? Explain. b. In fact, the elderly consume more medicine than younger people, and medicine costs have risen faster than overall inflation. What would you do to determine whether the elderly are actually better off from year to year? a. If the elderly consume the same market basket as other people, the Canada Pension Plan would provide the elderly with an improvement in their standard of living each year because the CPI overstates inflation and Canada Pension Plan payments are tied to the CPI. b. Since the elderly consume more health care than younger people, and since medicine costs have risen faster than overall inflation, it is possible that the elderly are worse off. To investigate this, you would need to put together a market basket for the elderly, which would have a higher weight on medicine. You would then compare the rise in the cost of the “elderly” basket with that of the general basket for CPI. 8. How do you think the basket of goods and services you buy differs from the basket bought by the typical Canadian household? Do you think you face a higher or lower inflation rate than is indicated by the CPI? Why? Many answers are possible. A common answer may be that as students, they spend a greater proportion of their income on tuition and books than the typical household. If the prices of tuition and books have risen faster than average prices, students face a higher inflation rate than the typical household. 9. Income tax brackets were not indexed until 2000. When inflation pushed up people’s nominal incomes during the 1970s, what do you think happened to real tax revenue? (Hint: This phenomenon was known as “bracket creep.”) When bracket creep occurred, inflation increased people’s nominal incomes, pushing them into higher tax brackets, so they had to pay a higher proportion of their incomes in taxes, even though they were not getting higher real incomes. As a result, real tax revenue rose. 10. When deciding how much of their income to save for retirement, should workers consider the real or the nominal interest rate that their savings will earn? Explain. In deciding how much income to save for retirement, workers should consider the real interest rate, since they care about their purchasing power in the future, not the number of dollars they will have. 11. Suppose that a borrower and a lender agree on the nominal interest rate to be paid on a loan. Then inflation turns out to be higher than they both expected. a. Is the real interest rate on this loan higher or lower than expected? b. Does the lender gain or lose from this unexpectedly high inflation? Does the borrower gain or lose? c. Inflation during the 1970s was much higher than most people had expected when the decade began. How did this affect homeowners who obtained fixed-rate mortgages during the 1960s? How did it affect the banks that lent the money? a. When inflation is higher than was expected, the real interest rate is lower than expected. For example, suppose the market equilibrium has an expected real interest rate of 3 percent and people expect inflation to be 4 percent, so the nominal interest rate is 7 percent. If inflation turns out to be 5 percent, the real interest rate is 7 percent minus 5 percent equals 2 percent, which is less than the 3 percent that was expected. b. Since the real interest rate is lower than was expected, the lender loses and the borrower gains. The borrower is repaying the loan with dollars that are worth less than was expected. c. Homeowners in the 1970s who had fixed-rate mortgages from the 1960s benefited from the unexpected inflation, while the banks that made the mortgage loans were harmed. Copyright © 2017 Nelson Education Ltd.