Price Indices and Inflation - AP Macroeconomics

1. How can governments combat inflation?

   Governments can use monetary policy to control inflation, such as adjusting interest rates. Central bank tools like interest rates affect money supply.

2. What is the 'base effect' in inflation measurement?

   The base effect is the impact of prior year price levels on the current inflation rate. Previous year's unusual prices distort current comparisons.

3. How does inflation impact fixed-income earners?

   Inflation erodes the purchasing power of fixed incomes. Fixed payments buy fewer goods as prices increase.

4. What is 'indexation'?

   Indexation is the automatic adjustment of income or payments by an index, like CPI. Links payments to price indices for automatic adjustments.

5. State the difference between nominal and real interest rates.

   Real interest rate = Nominal interest rate - Inflation rate. Real rate adjusts for inflation's effect on purchasing power.

6. Which term describes a decrease in the general price level?

   A decrease in the general price level is called deflation. Opposite of inflation; general price level falls.

7. Define 'stagflation'.

   Stagflation is a combination of stagnant economic growth and high inflation. Economic stagnation combined with rising price levels.

8. What does the term 'purchasing power' refer to?

   Purchasing power refers to the amount of goods or services that one unit of currency can buy. Measures how much real goods money can actually buy.

9. How are price indices used in economic analysis?

   Price indices are used to track inflation and make economic comparisons over time. Enable real comparisons by adjusting for price changes.

10. What is the 'shoe leather cost' of inflation?

    Shoe leather cost refers to the increased cost of transactions due to inflation. Time and effort spent managing cash during inflation.

11. State the formula for Real GDP.

    $\text{Real GDP} = \frac{\text{Nominal GDP}}{\text{GDP Deflator}} \times 100$. Adjusts nominal GDP by removing price level effects.

12. What is the formula for the Consumer Price Index (CPI)?

    $CPI = \frac{\text{Cost of Basket in Current Year}}{\text{Cost of Basket in Base Year}} \times 100$. Standard formula comparing current basket cost to base year cost.

13. What is the Laspeyres Index?

    The Laspeyres Index calculates price change using a fixed basket from the base period. Uses base-period quantities to isolate price effects.

14. What does it mean if the inflation rate is negative?

    Negative inflation rate indicates deflation. Prices are falling rather than rising over time.

15. Which price index is used to adjust Social Security payments?

    The Consumer Price Index (CPI) is used to adjust Social Security payments. CPI tracks the cost of living for benefit calculations.

16. Which index accounts for all goods and services produced domestically?

    The GDP deflator accounts for all goods and services produced domestically. Broader measure including investment and government spending.

17. What is the Fisher equation?

    Fisher equation: Nominal interest rate = Real interest rate + Inflation rate. Links nominal rates, real rates, and expected inflation.

18. How is inflation rate calculated using CPI?

    $Inflation Rate = \frac{\text{CPI}_{\text{current year}} - \text{CPI}_{\text{previous year}}}{\text{CPI}_{\text{previous year}}} \times 100$. Percentage change formula using consecutive year CPI values.

19. Which index measures wholesale price changes?

    The Producer Price Index (PPI) measures wholesale price changes. Tracks prices at the producer level before retail markup.

20. Identify the base year in a price index calculation.

    The base year is the year for which the price index is set to 100. Reference point for comparing price changes across years.

21. What is a cost-of-living adjustment (COLA)?

    COLA is an increase in income to maintain purchasing power during inflation. Protects real income from being eroded by rising prices.

22. What is the primary purpose of the GDP deflator?

    The GDP deflator measures inflation by comparing nominal and real GDP. Isolates price changes from quantity effects in GDP.

23. Identify a limitation of using CPI as a measure of inflation.

    CPI can overstate inflation because it does not account for changes in consumer behavior. Fixed basket ignores quality improvements and substitutions.

24. What is 'headline inflation'?

    Headline inflation includes all items in the CPI, including food and energy. Total inflation including all price components measured.

25. How is the inflation rate used in adjusting wages?

    Wages are adjusted for inflation to maintain purchasing power, often through COLAs. Ensures worker compensation keeps pace with rising costs.

26. What is the difference between CPI and core CPI?

    Core CPI excludes food and energy prices, while CPI includes all items. Core removes volatile food and energy price swings.

27. What happens to savings during periods of high inflation?

    The real value of savings decreases during high inflation. Fixed returns lose purchasing power as prices rise.

28. How does inflation affect the real value of money?

    Inflation decreases the real value of money, reducing purchasing power. Higher prices mean each dollar buys fewer goods.

29. What does CPI measure?

    CPI measures the average change in prices paid by urban consumers for goods and services. Focuses on household consumption patterns and costs.

30. What is the formula for the GDP deflator?

    $GDP Deflator = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100$. Ratio of nominal to real GDP, measuring overall price level.

31. What is 'bracket creep'?

    Bracket creep occurs when inflation pushes income into higher tax brackets. Inflation moves taxpayers into higher rate categories.

32. What is the 'substitution bias' in CPI?

    Substitution bias occurs when CPI does not account for consumers changing their buying habits. CPI uses fixed weights, missing consumer substitution effects.

33. Define 'menu costs' in the context of inflation.

    Menu costs are the costs to firms of changing prices due to inflation. Resources spent updating prices instead of production.

34. What is 'core inflation'?

    Core inflation excludes food and energy prices from the inflation calculation. Removes volatile components for clearer inflation trends.

35. Define 'basket of goods' in the context of CPI.

    A basket of goods is a fixed set of consumer products used to track price changes. Representative sample of goods used for price comparisons.

36. Which CPI component often has volatile prices?

    Food and energy prices are often volatile in the CPI. Supply shocks frequently affect these essential commodities.

37. What is hyperinflation?

    Hyperinflation is an extremely high and typically accelerating inflation rate. Occurs when inflation rates exceed 50% per month.

38. What is the purpose of a price index?

    A price index measures the average change in prices over time. Tracks how much prices have changed from a baseline period.

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