All price indexes contain certain distortions or biases that reduce their effectiveness as measures of inflation. Describe these distortions and how they affect price indexes
One distortion is caused by changes in product quality. For example, if the price of tires increases from $25 in 1970 to $80 in 1999, it looks like a $55 increase in the price of tires. But if the quality of the tires has changed over these years, then the dollar value people receive from the tires in 1999 may be as high as the dollar value they received from the 1970 tires. In other words, in real quality terms, prices haven't increased at all. Therefore, the true extent of inflation tends to be overstated in price indexes.
Another bias arises from the different kinds of goods that make up the basket. For example, if the base year is 1970 and remains at 1970 in the year 2000 . then the goods that we typically buy in 2000 . such as computers, are not represented in the basket. The basket becomes less reliable as a measure of changing prices. We must keep updating the base year to overcome this problem.
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Using the ISLM model, show graphically and explain the effects of a monetary contraction. What is the effect on the equilibrium interest rate and level of output?
What will be an ideal response?
In the consumer's NPV decision, the correct value for the interest rate R is
A) the interest rate that could be earned in a savings account when the consumer must borrow to finance the purchase. B) the interest rate that would have to be paid on a loan when the consumer could pay for the purchase with funds in a savings account. C) the interest rate charged for the loan when the consumer must borrow to finance the purchase. D) the prime rate, irrespective of whether when the consumer must borrow to finance the purchase. E) the prime rate plus the rate of inflation as measured by the CPI, irrespective of whether when the consumer must borrow to finance the purchase.