Question 1

As the rate of inflation increases, the increased cost to a consumer of more frequent trips to the bank to make cash withdrawals represents an increase in the:
A)shoe leather costs of inflation.
B)erosion of the purchasing power of cash.
C)tax distortion generated by inflation.
D)"noise" in the price system.

Accepted Answer

Shoe leather costs are any of the inconveniences people face when they need money for a transaction.

Question 2

The shoe leather costs of inflation include all of the following except:
A)the lost purchasing power of cash.
B)the extra costs incurred to avoid holding cash.
C)the cost of more frequent trips to the bank.
D)the installation of a new cash management system.

Accepted Answer

The "shoe leather" costs of inflation are the inconveniences that occur in dealing with cash during times of high inflation.

Question 3

Making more frequent, but smaller cash withdrawals from banks ________ the inflation losses from holding cash and ________ the shoe leather costs of inflation.
A)increases; increases
B)increases; reduces
C)reduces; has no impact on
D)reduces; increases

Accepted Answer

Keeping lower cash balances reduces the loss from inflation but increases the inconvenience of inflation by requiring more frequent trips to the bank or ATMs.

Question 4

Shoe leather costs include the ________ due to the more frequent trips to the bank, the new cash management systems and the expanded employment in banks that inflation causes.
A)bracket creep and redistribution that occur
B)deflating and indexing that are necessary
C)substitution and price adjustment biases that arise
D)time and effort that are used up

Accepted Answer

Shoe leather costs are any of the inconveniences people face when they need money for a transaction.

Question 5

The phenomenon known as ________ occurs when inflation causes people to pay an increasing percentage of their income in taxes even when their real incomes have not changed.
A)hyperinflation
B)bracket creep
C)the Fisher effect
D)substitution bias

Accepted Answer

This is the definition of 'bracket creep." This was a huge problem in the 1960's and 1970's when inflation rates were high.

Question 6

Suppose a borrower and lender agree to an interest rate on a loan when inflation is expected to be 6 percent. The borrower would benefit the most if which of the following inflation rates actually occurred?
A)0 percent
B)3 percent
C)6 percent
D)9 percent

Accepted Answer

The higher the inflation rate, the more devalued are the dollars the borrower repays.

Question 7

If a borrower and lender agree to an interest rate on a loan when inflation is expected to be 7 percent and inflation turns out to be 10 percent over the life of the loan, then the borrower ________ and the lender ________.
A)gains; gains
B)gains; loses
C)is not affected; gains
D)loses; gains

Accepted Answer

In this case, there was unanticipated inflation of 3 percent. This worked to the advantage of the borrower who paid back dollars that were less valuable than the two parties expected at the signing of the contract.

Question 8

If workers and employers agree to a three-year wage contract under the expectation of 3 percent inflation, and inflation turns out to be 5 percent, then:
A)workers gain and employers gain.
B)workers gain and employers lose.
C)workers lose and employers gain.
D)workers lose and employers lose.

Accepted Answer

Workers lose because their wages just went up 3 percent per year whereas average prices went up 5 percent, so their real incomes fell.

Question 9

To prevent people paying a higher percentage of their income in taxes even when their real incomes have not changed, Congress:
A)implemented a flat tax.
B)reduced the capital gains tax.
C)indexed the income tax brackets to the CPI.
D)deflated the income tax brackets to the CPI.

Accepted Answer

Congress indexed income taxes in the 1980's to prevent "bracket creep."

Question 10

The extra costs incurred to avoid holding cash when there is inflation are called the:
A)average costs of inflation.
B)consumer price index costs.
C)external costs.
D)shoe leather costs.

Accepted Answer

The extra costs incurred to avoid holding cash when there is inflation are called shoe leather costs.

Question 11

The real costs of inflation to society include:
A)an increase in the general level of prices.
B)lost purchasing power of income.
C)higher relative prices.
D)interference with long-term planning.

Accepted Answer

If inflation is unanticipated, parties to long-term contracts are uncertain about the value of repaid dollars, so these contracts are sometimes not written. Note that income will only lose purchasing power if it is not adequately adjusted for inflation.

Question 12

It is difficult to engage in long-term financial planning when inflation is:
A)high and erratic.
B)low and stable.
C)accounted for through indexing.
D)predictable.

Accepted Answer

The word "erratic" is important here. If inflation is erratic, parties to long-term contracts are uncertain about the worth of repaid dollars.

Question 13

Inflation ________ the signals sent by price changes to demanders and suppliers of goods and services.
A)amplifies
B)obscures
C)enhances
D)has no impact on

Accepted Answer

This may be the biggest problem with price movement: it is hard to distinguish between changes in the general price level and changes in a specific good's price.

Question 14

The "true" costs of inflation to an economy include all of the following except:
A)shoe-leather costs.
B)higher relative prices.
C)noise in the price system.
D)unexpected redistribution of wealth.

Accepted Answer

Higher relative prices indicate that a particular good or service has become more scares compared to others. This phenomenon is not necessarily related to inflation.

Question 15

Suppose workers and employers agree to a three-year wage contract under the expectation of 3 percent inflation, but inflation turns out to be 1 percent. In this case, ________ lost purchasing power, and ________ gained purchasing power.
A)employers; workers
B)no one; employers
C)workers; employers
D)employers; no one

Accepted Answer

Employers lose because their wage bill went up 3 percent per year whereas average prices went up 1 percent, so employer purchasing power fell. At the same time, the workers saw their purchasing power increase as their nominal income rose more than average prices.

Question 16

The "true" costs of inflation are:
A)higher relative prices.
B)lower relative prices.
C)reduced economic growth and efficiency.
D)a higher overall price level.

Accepted Answer

The "true" costs of inflation include reduced efficiency of the market system as inflation makes it difficult to distinguish relative price changes from changes in the general level of prices.

Question 17

When inflation turns out to be different from what was expected, purchasing power is ________.
A)destroyed
B)redistributed
C)increased
D)decreased

Accepted Answer

When unanticipated inflation occurs, an arbitrary redistribution of wealth or purchasing power occurs because some parties are helped and other parties are hurt by the inflation.

Question 18

If workers and employers agree to a three-year wage contract under the expectation of 5 percent inflation, and inflation turns out to be 3 percent, then:
A)workers gain and employers gain.
B)workers gain and employers lose.
C)workers lose and employers gain.
D)workers lose and employers lose.

Accepted Answer

Workers gain because their wages just went up 5 percent per year whereas average prices went up 3 percent, so their real incomes increased.

Question 19

Inflation makes it difficult to distinguish relative price changes from changes in the general level of prices. Consequently, inflation ________ the efficiency of the market system.
A)increases
B)decreases
C)does not change
D)may either increase or decrease

Accepted Answer

This may be the biggest problem with price movement: it is hard to distinguish between changes in the general price level and changes in a specific good's price.

Question 20

In Econoland in 2005, people with incomes between $20,000 and $30,000 paid 12 percent of their income in taxes and people with incomes between $30,001 and $40,000 paid 15 percent. In 2005, the CPI in Econoland equaled 1.20, and it increased to 1.26 in 2006. If the government of Econoland wants to keep households with a given real income from being pushed up into a higher tax bracket by inflation, the $20,000-to-$30,000 bracket will be changed in 2006 to:
A)$15,873 to $23,810.
B)$21,000 to $31,500.
C)$24,000 to $37,800.
D)$25,200 to $37,800.

Accepted Answer

The inflation rate between 2005 and 2006 was: (1.26 - 1.20)/ 1.20 = 0.05 or 5 percent, so the tax bracket needs to be adjusted by that amount: $20,000 × 1.05 = $21,000 and $30,000 × 1.05 = $31,500.

Quiz 18: Measuring the Price Level and Inflation

As the rate of inflation increases, the increased cost to a consumer of more frequent trips to the bank to make cash withdrawals represents an increase in the:

The shoe leather costs of inflation include all of the following except:

Making more frequent, but smaller cash withdrawals from banks the inflation losses from holding cash and the shoe leather costs of inflation.

Shoe leather costs include the ________ due to the more frequent trips to the bank, the new cash management systems and the expanded employment in banks that inflation causes.

The phenomenon known as ________ occurs when inflation causes people to pay an increasing percentage of their income in taxes even when their real incomes have not changed.

Suppose a borrower and lender agree to an interest rate on a loan when inflation is expected to be 6 percent. The borrower would benefit the most if which of the following inflation rates actually occurred?

If a borrower and lender agree to an interest rate on a loan when inflation is expected to be 7 percent and inflation turns out to be 10 percent over the life of the loan, then the borrower and the lender .

If workers and employers agree to a three-year wage contract under the expectation of 3 percent inflation, and inflation turns out to be 5 percent, then:

To prevent people paying a higher percentage of their income in taxes even when their real incomes have not changed, Congress:

The extra costs incurred to avoid holding cash when there is inflation are called the:

The real costs of inflation to society include:

It is difficult to engage in long-term financial planning when inflation is:

Inflation ________ the signals sent by price changes to demanders and suppliers of goods and services.

The "true" costs of inflation to an economy include all of the following except:

Suppose workers and employers agree to a three-year wage contract under the expectation of 3 percent inflation, but inflation turns out to be 1 percent. In this case, lost purchasing power, and gained purchasing power.

The "true" costs of inflation are:

When inflation turns out to be different from what was expected, purchasing power is ________.

If workers and employers agree to a three-year wage contract under the expectation of 5 percent inflation, and inflation turns out to be 3 percent, then:

Inflation makes it difficult to distinguish relative price changes from changes in the general level of prices. Consequently, inflation ________ the efficiency of the market system.