Question 1

A labor contract provides for a first-year wage of $10 per hour, and specifies that the real wage will rise by 3 percent in the second year of the contract. The CPI is 1.00 in the first year and 1.07 in the second year. What dollar wage must be paid in the second year?

Accepted Answer

To find the indexed wage in year two, the wage that would maintain the purchasing power from the first year, take the nominal wage in year one and multiply it by the CPI:, $10 × 1.07 = $10.70. Then, since the contract calls for an increase in the real wage by 3 percent, the indexed wage must be increased by 3 percent: $10.70 × 1.03 = $11.02.

Question 2

If you wish to maintain a constant purchasing power when you retire, you should choose retirement income options that are:

Accepted Answer

Indexing keeps wages and prices increasing at the same rate as inflation.

Question 3

A labor contract provides for a first-year wage of $15 per hour, and specifies that the real wage will rise by 2 percent in the second year of the contract and by another 2 percent in the third year. The CPI is 1.00 in the first year, 1.09 in the second year, and 1.15 in the third year. What dollar wage must be paid in the third year?

Accepted Answer

Note that since the first year is also the base year, the real wage and nominal wage are both $15 per hour in that year. Since the real wage is supposed to increase by 2 percent in the second year, the real wage in year two must be $15.30 ($15 × 1.02)per hour. Similarly, the real wage should also increase by 2 percent in the third year, so the real wage in year three must be $15.606 ($15.30 × 1.02)per hour. In order to find the nominal wage in year three, we must index this real wage to adjust for inflation. The nominal wage in year three must be $17.95 ($15.606 × 1.15).

Question 4

A labor contract provides for a first-year wage of $10 per hour, and specifies that the real wage will rise by 3 percent in the second year of the contract and by another 3 percent in the third year. The CPI is 1.00 in the first year, 1.07 in the second year, and 1.15 in the third year. What dollar wage must be paid in the third year?

Accepted Answer

Note that since the first year is also the base year, the real wage and nominal wage are both $10 per hour in that year. Since the real wage is supposed to increase by 3 percent in the second year, the real wage in year two must be $10.30 ($10 × 1.03)per hour. Similarly, the real wage should also increase by 3 percent in the third year, so the real wage in year three must be $10.609 ($10.3 × 1.03)per hour. In order to find the nominal wage in year three, we must index this real wage to adjust for inflation. The nominal wage in year three must be $12.20 ($10.609 × 1.15).

Question 5

Indexing is the process of:

Accepted Answer

Indexing is the practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index.

Question 6

Suppose the CPI does indeed overstate the inflation rate. When the CPI increases by 5 percent and household incomes increase by 5 percent, we should conclude that real incomes of households have:

Accepted Answer

If the CPI and household income increased at the same rate, economists would conclude that this household is not experiencing an increase in their real income.

Question 7

Because the minimum wage is not indexed to inflation, when there is inflation the nominal minimum wage ________, and the real minimum wage ________.

Accepted Answer

Income that is not indexed to inflation loses purchasing power over time when inflation occurs. In the case of the minimum wage, it is constant in nominal terms but decreases in real terms.

Question 8

The practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index is called:

Accepted Answer

Indexing is the practice of increasing a nominal quantity each period by an amount equal to the percentage increase in a specified price index.

Question 9

Suppose manufacturers introduce a new model car to replace a car currently included in the CPI basket. The price of the new car is 10 percent higher than the discontinued model, but the new car has additional safety features and amenities. In this situation the CPI will tend to ________ inflation as a result of ________ bias.

Accepted Answer

The CPI did not fully reflect the higher quality of the new car, so it overstated the price increase. This is called "quality adjustment" bias.

Question 10

Two methods used to adjust nominal values for inflation are:

Accepted Answer

Indexing increases nominal amounts by the rate of inflation each year to maintain a certain real value, while deflating is the process of obtaining real values from nominal ones.

Question 11

If workers received a 5 percent wage increase and the rate of inflation was 5 percent, then their real wage:

Accepted Answer

In this case, nominal wages rose at the same rate of inflation, so real wages remained constant.

Question 12

The process of converting current dollar values into real terms is called ________, while the process of adjusting nominal quantities to maintain their purchasing power is called ________.

Accepted Answer

The process of converting current dollar values into real terms is called deflating, while the process of adjusting nominal quantities to maintain their purchasing power is called indexing.

Question 13

A report indicated that the average real wage in manufacturing declined by 2 percent between 1990 and 2000. If the CPI equaled 1.30 in 1990, 1.69 in 2000, and the average nominal wage in manufacturing was $35 in 2000, what was the average nominal wage in manufacturing in 1990?

Accepted Answer

The real wage in 2000 was $20.71($35/1.69). This real wage is 98 percent, or (0.98), of the real wage in 1990. So the real wage 2000 = real wage 1990 × 0.98, or 20.71 = real age 1990 × 0.98. We solve for the real wage in 1990, by dividing each side with 0.98: $20.71/0.98 = 21.13. Finally we can obtain the nominal wage for 1990 by multiplying the real wage in 1990 with the CPI in 1990: 21.13 × 1.3 = $27.47.

Question 14

To ensure that your salary maintains its real purchasing power from year to year, your nominal salary must be:

Accepted Answer

Indexing is the act of increasing nominal amounts by the inflation index to ensure that salaries keep up with inflation.

Question 15

A labor contract provides for a first-year wage of $15 per hour, and specifies that the real wage will rise by 2 percent in the second year of the contract. The CPI is 1.00 in the first year and 1.09 in the second year. What dollar wage must be paid in the second year?

Accepted Answer

To find the indexed wage in year two, the wage that would maintain the purchasing power from the first year, take the nominal wage in year one and multiply it by the CPI:, $15 × 1.09 = $16.35. Then, since the contract calls for an increase in the real wage by 3 percent, the indexed wage must be increased by 2 percent: $16.35 × 1.02 = $16.68.

Question 16

To ensure that a nominal payment represents a constant level of purchasing power over time, one should:

Accepted Answer

To keep nominal amounts constant in real terms, increase nominal amounts by the rate of inflation each year.

Question 17

The CPI equals 1.00 in year one and 1.15 in year two. If the nominal wage is $15 in year one and a contract calls for the wage to be indexed to the CPI, what will be the nominal wage in year two?

Accepted Answer

To find the indexed wage in year two, take the nominal wage in year one and multiply it by the CPI, i.e., $15 × 1.15 = $17.25.

Question 18

The CPI equals 1.00 in year one and 1.05 in year two. If the nominal wage is $15 in year one and a contract calls for the wage to be indexed to the CPI, what will be the nominal wage in year two?

Accepted Answer

To find the indexed wage in year two, take the nominal wage in year one and multiply it by the CPI, i.e., $15 × 1.05 = $15.75.

Question 19

A factory worker earned $10 an hour in 1980. The CPI was 0.82 in 1980. The same factory worker was earning $15 an hour in 1990 when the CPI was 1.31. From 1980 to 1990, the factory worker's hourly real wage:

Accepted Answer

Real hourly wage decreased from $12.20 (i.e., $10/0.82)to $11.45 (i.e., $15/1.31).

Question 20

When statisticians fail to take into account improvements in the quality of goods and services, the CPI will tend to ________ the rate of inflation.

Accepted Answer

It's hard to correctly factor in improvement to the quality of goods and services. To the extent that quality improvements are not fully accounted for, the CPI overstates the "true" inflation rate.

Quiz 18: Measuring the Price Level and Inflation