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The consumer price index is used to monitor changes in an economy's production of goods and services over time.

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False - CPI tracks the changes in prices, not production.

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When the consumer price index falls, the typical family has to spend fewer dollars to maintain the
same standard of living.

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True

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Economists use the term inflation to describe a situation in which the economy's overall price level is rising.

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True

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Inflation can be measured using either the GDP deflator or the consumer price index.

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True

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Because the consumer price index reflects the goods and services bought by consumers better than the GDP deflator does, it is more useful in guiding policy changes.

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True

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The CPI is a measure of the overall cost of the goods and services bought by a typical consumer.

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True

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The Bureau of Labor Statistics surveys consumers to determine a fixed basket of goods.

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True

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The content of the basket of goods and services used to compute the CPI changes every month.

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False - CPI is all about fixed basket so that any change in the index only reflects the changes in prices, not the changes in quantities or items.

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By keeping the basket of goods and services the same when computing the CPI, the Bureau of Labor Statistics isolates the effects of price changes from the effect of any quantity changes that might be occurring at the same time.

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True

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When the consumer price index is computed, the base year is always the first year among the years being considered.

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False - Any year is fine and the choice of the base year does not affect the year-to-year inflation based on CPI.

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The CPI for 2008 is computed by dividing the price of the basket of goods and services in 2008 by the price of the basket of goods and services in the base year, then multiplying by 100.

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True

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The CPI is always 1 in the base year.

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False - The CPI is always 100 in the base year.

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If the current year CPI is 140, then the price level has increased 40% since the base year.

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True

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The inflation rate for 2007 is computed by dividing (the CPI in 2007 minus the CPI in 2006) by the CPI in 2006, then multiplying by 100.

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True

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If the value of the consumer price index is 110 in 2005 and 121 in 2006, then the inflation rate is 11% for 2006.

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False - inflation 2006 = [(CPI_2006 - CPI_2005)/CPI_2005] x 100 = [(121- 110)/110] x 100 = 10%

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If the consumer price index is 120 in 2009 and 139.2 in 2010, then the rate of inflation for 2010 is
39.2%.

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False - inflation 2010 = [(139.2- 120)/120] x 100 = 16%

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Substitution bias occurs because the CPI ignores the possibility of consumer substitution toward
goods that have become relatively less expensive.

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True

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Substitution bias causes the CPI to understate the increase in the cost of living from one year to the next.

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False - the CPI overstates the cost of living increases.

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The CPI does not reflect the increase in the value of the dollar that arises from the introduction
of new goods.

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True

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The Bureau of Labor Statistics does not try to account for quality changes in the goods and services in the basket used to compute the CPI.

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False - BLS takes the quality changes into account using hedonic method.

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When the price of Italian wine rises, this change is reflected in the U.S. CPI but not in the U.S.
GDP deflator.

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True - CPI covers items purchased by a typical consumer including foreign goods, GDP deflator only covers domestically produced goods and services.

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When the price of nuclear missiles rises, this change is reflected in the CPI but not in the GDP deflator.

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False - Nuclear missiles are NOT purchased by a typical consumer, so it's not part of the CPI. If these missiles are produced domestically, GDP deflator reflects their price changes.

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The group of goods and services used to compute the GDP deflator changes automatically over time, but the group of goods and services used to compute the CPI does not.

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True

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If the CPI today is 120 and the CPI five years ago was 80, then something that cost $1 five years ago would cost $1.50 in today's prices.

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True - Today's value = (Today's CPI/CPI of 5 years ago) x $1 = (120/80) x $1 = $1.5

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Henry Ford paid his workers $5 a day in 1914, when the CPI was 10. Today, with the price index
at 177, the $5 a day is worth $88.50.

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True - Today's value = (177/10) x $5 = $88.5

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If you currently make $25,000 a year and the CPI rises from 110 today to 150 in five years, then
you need to be making $43,333.33 in five years to have kept pace with consumer price inflation.

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False - Future value of today's $25,000 = (150/110) x $25,000 = $34,091

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When some dollar amount is automatically corrected for inflation by law or contract, the amount
is said to be indexed for inflation.

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T

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Bob deposits $100 in a bank account that pays an annual interest rate of 5%. A year later, Bob withdraws his $105. If inflation was 2% during the year the money was deposited, then Bob's purchasing power has increased by 3%.

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True - Fisher equation: nominal interest rate (5%) = real interest rate + inflation (2%)Ãž Real interest rate = 3% = growth rate of the purchase power of the bank balance

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Bob deposits $100 in a bank account that pays an annual interest rate of 5%. A year later, Bob withdraws his $105. If inflation was 5% during the year the money was deposited, then Bob's purchasing power has not changed.

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True - Fisher equation: nominal interest rate (5%) = real interest rate + inflation (5%) Ãž Real interest rate = 0%
Ãž growth rate of the purchase power of the bank balance = 0 (unchanged overtime)

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Bob deposits $100 in a bank account that pays an annual interest rate of 5%. A year later, Bob withdraws his $105. If inflation was 7% during the year the money was deposited, then Bob's purchasing power has increased by 2%.

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False - Fisher equation: nominal interest rate (5%) = real interest rate + inflation (7%) Ãž Real interest rate = -2%
Ãž The purchasing power of Bob's bank balance has decreased by 2%.

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The real interest rate measures the change in dollar amounts.

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False - The real interest rate measures the change in the purchasing power. The nominal interest rate measures the change in dollar amounts.

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The real interest rate is the interest rate corrected for inflation.

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True

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The nominal interest rate tells you how fast the number of dollars in your bank account rises over time.

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True

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The real interest rate tells you how fast the purchasing power of your bank account rises over time.

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True

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If the nominal interest rates rises, then the inflation rate must have increased.

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False

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If the nominal interest rate is 5% and the inflation rate is 2%, then the real interest rate is 7%.

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False - Fisher equation: nominal interest rate = real interest rate + inflationÃž Real interest rate = nominal interest rate - inflation = 5% - 2% = 3%

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If the nominal interest rate is 5% and the real interest rate is 2%, then the inflation rate is 3%.

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True - Fisher equation: nominal interest rate = real interest rate + inflationÃž inflation = nominal interest rate - real interest rate = 5% - 2% = 3%

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If the real interest rate is 5% and the inflation rate is 2%, then the nominal interest rate is 7%.

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True - Fisher equation: nominal interest rate = real interest rate (5%) + inflation (2%) = 7%

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It is possible to observe a positive nominal interest rate together with a negative real interest
rate.

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True - where inflation is very high.

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Kristine has a savings account at a bank. If the nominal interest rate she earns exceeds the rate
of inflation, then her purchasing power increases over time.

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True

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Substitution Bias

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- As some prices rise faster than others, consumers substitute toward goods that become relatively cheaper.
- The CPI misses this substitution because it uses a fixed basket.
- Thus , the CPI overstates increases in the cost of living

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Introduction of New Goods

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-People's consumption behavior changes when new goods are introduced to consumers.
- The CPI misses this effect because it uses a fixed basket of goods.

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Unmeasured Quality Change

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- The BLS uses the Hedonic Method to account for quality changes.

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â€¢Comparing dollar figures from different times (locations)

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- Babe Ruth's Salary was $80,000 in 1931.
- Alex Rodriguez's Salary was $25.2 million in 2007.
- Who's paid more?

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â€¢Indexation

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- Cost Of Living Allowance (COLA)
- Inflation adjustment of most salary contracts.
- Social Security COLA

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â€¢Real and Nominal Interest Rates

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- Interest Rate on Savings account is 2% per year.
- If inflation rate is 3%, do I become richer with the saving?

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Indexation: Cost Of Living Adjustment (COLA)

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- Various nominal compensation is indexed to a price index to maintain a certain level of real income.
- Employment/salary contracts (based on predicted value).
- Social security payment plans (subject to annual adjustments after the issue of September CPI)

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The Fisher Equation:

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r=i-pi

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Nominal interest rate :

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- growth rate of the balance of the (bank) accoun

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Real interest rate:

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- growth rate of the purchasing power of the (bank) account

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Using the fisher equation

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you can calculate the real interest rate of your bank account using the nominal interest rate (shown on the statement) and the inflation rate (reported every month by BLS)