Question 1:
Jane has a locket containing a lock of David Hume’s hair. Bob has offered to purchase it from her for $20,000 today. Ling has offered to purchase it for a first payment of $8,000 today and a second payment of $13,000 in a year’s time.
(a) If Jane expects inflation of 5% in the next year, which buyer’s offer has the greatest real value?
(b) If Jane expects inflation of 10% in the next year, which buyer offer has the greatest real value
Question 2:
The Gringotts Bank lends $1,000 to Mr A Filch on the condition that he repays the principal with 5% simple interest in one year’s time.
(a) If the inflation rate over the next year is 3%, what is the real value of Mr Filch’s repayment in today’s dollars?
(b) Using your answer to part a), what was the real interest rate of the loan based on the exact equation for the real interest rate?
(c) If the inflation rate over the next year is 7%, what is the real value of Mr Filch’s repayment in today’s dollars?
(d) Using your answer to part c), what was the real interest rate of the loan using the exact equation for the real interest rate?
(e) Using the approximated equation (), calculate the real interest rates from part (b) and (d). (Note: the approximate equation is known as Fischer equation.)
(f) What do your answers to part (e) mean?
(g) What effect does unexpectedly high inflation have on the wealth of borrowers and lenders?
(h) What effect does unexpectedly low inflation have on the wealth of borrowers and lenders?
Question 3
Consider the following production data for Kuznetsistan whose people consume only milk and juice.
2012
2013
Quantity
Price
Quantity
Price
Milk
5L
$4/L
4L
$8/L
Juice
2L
$2/L
4L
$4/L
(a) Using 2012 as the base year, what is the CPI in 2013?
(b) Using your answer to part (a) what was the inflation rate between 2012 and 2013?
Question 4:
Nanna Nakamura is a very thrifty woman and she has saved $100,000 and is keeping it in cash under her mattress. She lives in a country deflation and the CPI will fall from 400 this year to 380 next year.
a) What is deflation?
b) In today’s dollars, what will the real value of Nana Nakamura’s cash be in a year?
c) If Nanna Nakamura is aware of the present deflationary trend and she expects it to continue, what impact do you think this will have on her spending habits?
Question 5:
Consider the following data for Australia
1966
2014
Average male weekly earnings
$57.00
$1648.20
Consumer Price Index (base year 2012)
8.6
104.8
a) What is the percentage change in real average male weekly earnings between 1966 and 2014?
b) How do you interpret your answer to part a)?
c) Considering how CPI is calculated and its likely biases, do you think your answer to part a) overstates or understates the true effect?