Inflation is a continuing rise in the general level of prices of goods and services. It can also be defined as a decline in the value (the purchasing power) of the monetary unit. There is too much money chasing too few goods.

• It is a rise in the price level, not in the price of a particular commodity. Individual prices rise and fall all the time in a market economy, reflecting consumer choices or preferences and changing costs.
• It is an ongoing process, not a one-time jump in the price level.

There are different types of inflation.

• Deflation is a decrease in the general price level of goods and services.
• Disinflation is a slowing in the rate of increase in the general price level.
• Hyperinflation indicates a very high and increasing rate of inflation.

The annual inflation rate is simply the percentage change in the price index (PI) from one year to the next:

For example, the CPI is 115 for 2010 and 120 for 2011. The inflation rate during 2011 is: (120 - 115)/115 = 4.35%.

The Laspeyres index uses the same group of commodities purchased in the base period.

• Advantages: It requires quantity data from only the base period. This allows a more meaningful comparison over time. The changes in the index can be attributed to changes in the price.
• Disadvantages: It does not reflect changes in buying patterns over time. It may also overweight goods when prices increase.

The Paasche index uses the current composition of the basket. It tends to understate inflation.

The Fisher index is the geometric mean of the two indices.

Many countries use their own consumer price indices to track domestic inflation. These indices have different names and baskets.

Inflation is not simply a matter of rising prices. In the long run, inflation occurs if the quantity of money grows faster than potential GDP. In the short run, there are endemic and perhaps diverse reasons for causes at the root of inflation.

Inflation can result from either an increase in aggregate demand (demand-pull inflation) or a decrease in aggregate supply (cost-push inflation).

• Cost-push inflation is a result of decreased aggregate supply as well as increased costs of production (itself a result of different factors). It basically means that prices have been "pushed up" by increases in the costs of any of the production factors (money wage rate and money price of raw materials) when companies are already running at full production capacity. Increased costs are passed on to consumers, causing a rise in the general price level (inflation).
  • The non-accelerating inflation rate of unemployment (NAIRU), or the natural rate of unemployment (NARU), is defined as the rate of unemployment when the rate of wage inflation is stable.
  • The unit labor cost (ULC) indicator is calculated as total compensation per worker divided by total output per worker. Higher labor costs may pass through to prices.

• Demand-pull inflation occurs when total demand for goods and services exceeds total supply. Buyers, in essence, "bid prices up" and cause inflation. This excessive demand usually occurs in an expanding economy.
  The increase in aggregate demand that causes demand-pull inflation can be the result of various economic dynamics. For example, the authorities may allow the money supply to grow faster than the ability of the economy to supply goods and services, so there is "too much money chasing too few goods." Increases in government purchases and depreciations of local exchange rates can also increase aggregate demand and start demand-pull inflation. However, only an ongoing increase in the quantity of money can sustain it.

If an economy identifies what type of inflation is occurring (cost-push or demand-pull), then the economy may be better able to rectify (if necessary) rising prices and loss of purchasing power.

Practice Question 1

If the CPI in 2010 is 120 and it rises to 180 during 2011, the inflation rate between the two years is ______.

A. 180%
B. 100%
C. 50%

Correct Answer: C

Practice Question 2

The main sources of bias in the CPI include all of the following EXCEPT FOR ______.

A. commodity substitution
B. price changes
C. quality changes
D. new goods

Correct Answer: B

Practice Question 3

If the inflation rate is less than 0%, it is called ______.

A. deflation
B. disinflation
C. neflation

Correct Answer: A

Deflation refers to a persistent fall in the level of the overall consumer price index, with negative inflation being recorded year after year.

Practice Question 4

Inflation can result from ______.

I. a decrease in aggregate demand
II. an increase in aggregate demand
III. a decrease in aggregate supply
IV. an increase in aggregate supply

Correct Answer: II and III

Practice Question 5

A slowing in the rate of price inflation is called ______.

A. deflation
B. disinflation
C. slow inflation

Correct Answer: B

Disinflation is defined as a drop in the inflation rate.

Practice Question 6

In Germany between January 1922 and November 1923, the average price level increased by a factor of 20 billion, doubling every 28 hours. This is called ______.

A. deflation
B. superinflation
C. hyperinflation

Correct Answer: C

Hyperinflation is an extremely fast increase in aggregate price level.

Practice Question 7

The substitution bias means the Laspeyres index often shows ______ bias.

A. an upward
B. a downward
C. either a downward or an upward

Correct Answer: A

The Laspeyres index overstates the rise in prices, because it does not take account of substitution away from goods as they become more expensive relative to other goods.

Practice Question 8

Demand-pull inflation can be caused by ______.

I. increases in investment
II. increases in exports
III. increases in imports
IV. a restrictive fiscal policy
V. an expansionary monetary policy
VI. an appreciation of home currency

Correct Answer: I, II and V

Practice Question 9

The Fisher index is the ______ of the Laspeyres index and the Paasche Index.

A. arithmetic mean
B. geometric mean
C. sum

Correct Answer: B

Practice Question 10

A chained price index formula such as the Fisher index can somewhat resolve the ______ bias of the Laspeyres index.

A. substitution
B. quality
C. new product

Correct Answer: A

Practice Question 11

The following dataset shows the change of a consumption basket over time:

2013 (price/quantity)- Bread: $0.77/50; Milk: $1.22/30
2014 (price/quantity)- Bread: $0.80/52; Milk: $1.24/28

The denominator of the Laspeyres index should be calculated as ______.

A. $0.77 x 50 + 1.22 x 30
B. $0.80 x 52 + 1.24 x 28
C. $0.77 x 52 + 1.22 x 28

Correct Answer: A

The Laspeyres index uses the same quantity data from only the base period. B is the numerator and C is the denominator of the Paasche index.

Practice Question 12

In the U.S. the Consumer Price Index (CPI) is calculated using a ______ (fixed or different) basket of goods and will tend to ______ (overstate or understate) inflation.

Correct Answer: fixed; overstate

Since the CPI uses a fixed basket, it will not compensate for the fact that people will substitute away from goods with prices that are rising more rapidly than other prices. The result will be an overestimate of the inflation rate.

Practice Question 13

Which of the following is NOT a true statement about the Consumer Price Index (CPI) and the GDP deflator?

A. The CPI is based on a fixed market basket of goods while the GDP deflator is based on all goods produced in the country.
B. The CPI includes imports and used goods while the GDP deflator does not.
C. The CPI tends to overstate inflation but the GDP deflator does not.
D. Neither the CPI nor the GDP deflator adjusts for quality improvements in goods.

Correct Answer: C

Most economists believe that all price indexes tend to overstate inflation because none can adequately adjust for quality improvements in goods.

Practice Question 14

If actual unemployment falls below the NAIRU, theory suggests that ______

A. cost-push inflation may occur.
B. demand-pull inflation may occur.
C. the actual unemployment rate will be higher than the natural rate of unemployment.

Correct Answer: A

In this case, the balance of power in the labour market tends to switch to employees rather than employers.

Practice Question 15

Suppose that the unemployment rate is at 5% and the inflation rate is 2%. Assuming that both of these values remain the same for a period of years, it can be said that the ______

I. non-accelerating inflation rate of unemployment is 5%.
II. natural rate of unemployment is 5%.

Correct Answer: Both I and II

The non-accelerating inflation rate of unemployment is the specific level of unemployment that exists in an economy that does not cause inflation to increase. When unemployment is under 5%, it is natural for an inflation rate of 2% to correspond with it.

Practice Question 16

If the cost of a basket of goods is $125 in 2009, $135 in 2010, and $150 in 2011, assuming 2011 is the base year, the CPI for 2009 is ______.

Correct Answer: 83

The formula for the CPI for a given year is: CPI = cost in a given year/cost in a base year*100. In this case, 125/150*100 = 83.

Practice Question 17

Cost-push inflation means prices are pushed up by ______.

I. increases in wages
II. appreciations of home currency
III. increases in raw material prices
IV. increases in investment demand
IV. increases in household demand

Correct Answer: I and III

Practice Question 18

In cost-push inflation, aggregate demand will ______ in the long run.

A. increase
B. remain the same
C. decrease

Correct Answer: A

In the long-term, demand will increase so the real GDP will be at the full-employment level.

Practice Question 19

The combination of a rise in the price level and a fall in real GDP is called ______.

A. hyperinflation
B. recession
C. stagflation

Correct Answer: C

This happens when the supply curve shifts leftward - the real GDP decreases and the price level rises.

Practice Question 20

In a cost-push inflation spiral, a cost-push increase in the price level leads to a situation in which real GDP is ______

A. above potential GDP and unemployment is above its natural rate.
B. below potential GDP and unemployment is below its natural rate.
C. below potential GDP and unemployment is above its natural rate.

Correct Answer: C

This is the start of cost-push inflation.

Practice Question 21

Inflationary expectations are important because widespread changes in inflationary expectations affect ______.

A. relative prices
B. actual inflation
C. unexpected inflation

Correct Answer: B

If people expect more inflation, they will bargain for higher wages and prices, which will in turn generate more inflation.

Practice Question 22

Higher than expected aggregate demand will result in an inflation that is like a ______ one.

A. demand-pull
B. demand-push
C. cost-pull

Correct Answer: A

Practice Question 23

The unemployment rate at full employment is called the ______ rate of unemployment.

A. frictional
B. potential
C. natural

Correct Answer: C

Practice Question 24

The opposite of inflation is ______.

A. deflation
B. disinflation
C. hyperinflation

Correct Answer: A

Deflation is a general decline in prices, often caused by a reduction in the supply of money or credit.

Practice Question 25

Between 1981 and 1983, the annual rate of increase in the Canadian total consumer price index (CPI) declined from 12.5% to just under 6%. Again, from 1990 to 1992, the rate of inflation slowed from about 5% to 1.5%. This is an example of ______.

A. inflation
B. deflation
C. disinflation

Correct Answer: C

Disinflation is a decrease in the rate of inflation.

Practice Question 26

Which statement is false?

A. Disinflation is a decrease in the rate of inflation.
B. Deflation causes an increase in the real value of money and other monetary items.
C. When disinflation occurs the aggregate price level starts to fall.

Correct Answer: C

When disinflation occurs the aggregate price level still keeps rising but at a slower speed.

Practice Question 27

All of the following occurrences could cause demand-pull inflation except an increase in ______.

A. government purchases and exports
B. money wage rates
C. the quantity of money

Correct Answer: B

An increase in money wage rates can cause cost-push inflation.

Practice Question 28

The new product bias means the Laspeyres index often shows ______ bias.

A. an upward
B. a downward
C. either a downward or an upward

Correct Answer: A

The price indices give no weight to future consumption, only to current consumption. This creates an upward bias in the inflation rate.

Practice Question 29

If the Laspeyres index is 120 and the Paasche index is 115, then the Fisher index is ______.

A. 117.5
B. 117.47
C. 235

Correct Answer: B

It is the geometric mean of the two indices.

Practice Question 30

The following dataset shows the change of a consumption basket over time:

2010 (price/quantity)- Bread: $0.77/50; Milk: $1.22/30
2011 (price/quantity)- Bread: $0.80/52; Milk: $1.24/28

The denominator of the Paasche index should be calculated as ______.

A. $0.77 x 50 + 1.22 x 30
B. $0.80 x 52 + 1.24 x 28
C. $0.77 x 52 + 1.22 x 28

Correct Answer: C

A is the denominator of the Laspeyres index and B is the numerator of both.

Practice Question 31

A job paid $8,700 in 1970, when the CPI was 29. In 2011, the CPI was 164. How much would you have to earn in 2011 to be making the same real wage?

A. $58,000
B. $164,000
C. Neither of the above answers is correct.

Correct Answer: C

In real terms, the 1970 wage = 8,700/29 = 300. Thus, 300*164= $49,200, the equivalent wage in 2011.

Practice Question 32

Suppose that the price level is 100 in 2005, 115 in 2006, and 125 in 2007. Over the period from 2005 to 2007, we can say that the price level has ______ while the inflation rate has ______.

A. increased; increased
B. increased; decreased
C. increased; remained constant

Correct Answer: B

The price level is clearly increasing over this period. The inflation rate is 15% in 2006 and 8.7% in 2007. Thus, the inflation rate is decreasing. This is an example of disinflation.

Practice Question 33

A client tells you that he currently earns $100,000 per year and is comfortable with his lifestyle at that income level. He says he is planning on retiring in 5 years. If inflation averages 8% over the next 5 years, approximately what income level will this client require in the year of his retirement to maintain his current lifestyle?

A. $147,000
B. $122,000
C. $140,000

Correct Answer: A

The calculation is as follows: (1.08)⁵ x 100000 = $146,933

Practice Question 34

Which rate determines when an economy will experience wage-push inflationary pressures?

A. The non-accelerating inflation rate of unemployment
B. The actual unemployment rate
C. The CPI-based inflation rate

Correct Answer: A

The NAIRU determines when an economy will experience bottlenecks in the labor market.

Practice Question 35

Social security payments have been adjusted for inflation annually since the late 1970s yet it is sometimes argued that the cost of living for retirees on social security rises less than the cost of living adjustment used by the government. If this is the case, ______

A. retirees are hurt by inflation even with the government's inflation adjustment.
B. retirees benefit from using the government's cost of living adjustment rather than a more accurate cost of living adjustment.
C. retirees would be better off if the government cost of living adjustment more accurately reflected the true cost of living for retirees.

Correct Answer: B

If social security payments more than keep pace with the true cost of living, retirees will be better off.

Practice Question 36

According to advocates of the quantity theory of money, a government that attempts to maintain a high level of output is likely to ______

A. be successful and generate a low rate of inflation.
B. generate considerable inflation, but not enough to really hurt the economy.
C. undermine the economy's future growth by producing a high level of inflation.

Correct Answer: C

Inflation undermines growth by creating uncertainty, by making it more difficult for businesses to enter into contracts, and by increasing the costs of avoiding inflation.

Practice Question 37

Higher than expected aggregate demand will result in an inflation that is like a ______ one.

A. demand-pull
B. demand-push
C. cost-push

Correct Answer: A

If aggregate demand grows faster than expected, real GDP moves above potential GDP, the inflation rate exceeds its expected rate, and the economy behaves like it does with demand-pull inflation.

Practice Question 38

Printing money ______

A. is superior to issuing bonds because it does not affect the debt.
B. is inferior to issuing bonds because it creates more inflation.
C. cannot be used to finance a deficit.

Correct Answer: B

Printing money is one way to finance an excess of expenditures over receipts, but it invariably produces higher inflation if it is sustained.

Practice Question 39

Which of the following will most likely lead to cost-push inflation?

A. A decrease in the cost of financing
B. A technology change that lowers production costs
C. An increase in the money prices of raw materials

Correct Answer: C

Increased material costs cause firms to manufacture less. Less manufacturing decreases short-run supply, making prices rise.

Practice Question 40

Suppose the CPI basket contains only two goods and services: oranges and haircuts. In the base period, consumers bought 15 oranges at $2 each and 5 haircuts at $10 each. In the current period, consumers buy 15 oranges at $1.75 each and 5 haircuts at $12 each. The CPI for the current period is closest to ______.

A. 107.81
B. 114.58
C. 117.97

Correct Answer: A

CPI equals 100 times the cost of the CPI basket at current-period prices divided by the cost of the CPI basket at base-period prices. In this problem, the current period cost is (15 x 1.75 + 5 x 12) = 86.25. The base period cost is (15 x 2 + 5 x 10) = 80. The CPI is (86.25 / 80) x 100 = 107.81.

Practice Question 41

The most likely initial (short-run) effect of demand-pull inflation is an increase in ______.

A. the price level and a decrease in real GDP
B. the price level and an increase in real GDP
C. government expenditure followed by a decline in the quantity of money

Correct Answer: B

The initial effect of demand-pull inflation is an increase in aggregate demand, which, in turn, leads to an increase in the real GDP.

Practice Question 42

Consider the following information regarding consumer price index (CPI) numbers for this year and last year.

CPI this year: 267.54
CPI last year: 261.25

The inflation rate (in %) for the period is closest to ______.

A. 2.36
B. 2.39
C. 2.41

Correct Answer: C

The inflation rate is calculated as: ((CPI this year - CPI last year) / CPI last year) x 100. In this question, the inflation rate is ((267.54 - 261.25) / 261.25) x 100 = 2.407656.