Calculations with Inflation

Inflation = / Priceslater / -1
Pricesearlier

Priceslater = Pricesearlier * (1 + Inflation)

Pricesearlier= / Priceslater
(1 + Inflation)

CountryLast Year’sThis Year’s Inflation

PricesPricesRate

Pizzastan 105 111 (a)

Beeritania (b) 214 1.4%

Margaritaville 167 341 (c)

Cactusleague 88 (d) 6.8%

Barbecua 1843 3012 (e)

First, calculate the values for (a) through (e), then answer the following questions:

1) Which country has the highest inflation rate?

  1. Beeritania
  2. Margaritaville
  3. Cactusleague
  4. Barbecua
  5. Not enough information to tell

2) Which country has the highest cost of living?

  1. Beeritania
  2. Margaritaville
  3. Cactusleague
  4. Barbecua
  5. Not enough information to tell

3) Which country has the lowest inflation rate?

  1. Beeritania
  2. Margaritaville
  3. Cactusleague
  4. Barbecua
  5. Not enough information to tell

4) Which country has the highest standard of living?

  1. Beeritania
  2. Margaritaville
  3. Cactusleague
  4. Barbecua
  5. Not enough information to tell

5) Assuming all real interest rates are about the same, which country will have the highest nominal interest rates?

  1. Beeritania
  2. Margaritaville
  3. Cactusleague
  4. Barbecua
  5. Not enough information to tell

6) Which country will have the highest velocity?

  1. Beeritania
  2. Margaritaville
  3. Cactusleague
  4. Barbecua
  5. Not enough information to tell

7) In which country is the central bank most likely expanding the money the fastest?

  1. Beeritania
  2. Margaritaville
  3. Cactusleague
  4. Barbecua
  5. Not enough information to tell

Answers:

(a) Use the first equation to calculate inflation: 111/105 -1 = 1.057 -1 = .057 = 5.7%

(b) Use the last equation to calculate prices earlier: 214 / (1 + 1.4%) = 214 / (1.014) = 211

(c) Use first equation to calculate inflation: 341 / 167 – 1 = 2.042 – 1 = 1.042 = 104.2%

(d) Use middle equation to “inflation” earlier prices: 88 * (1+6.8%) = 88 * 1.068 = 94

(e) Calculate inflation again: 3012 / 1843 -1 = 1.634 -1 = .634 = 63.4%

1)B. With an inflation rate of 104.2%, Margaritaville.

2)D. Prices are highest in Barbecua – the result of a lot of inflation in the past.

3)A. Beeritania with 1.4% is the lowest

4)E. To know that standard of living, we’d need to know real income. If we had nominal income, we could calculate real, but we don’t have any income measure. Not enough information. Just because one country has higher or lower prices doesn’t mean the standard of living is lower or higher. There’s no reason to believe nominal income is the same in all of the countries.

5)B. The country with the highest inflation rate will have the highest nominal interest rates (Fisher effect).

6)B. The country with the highest inflation rate, where the nominal interest rate is the highest, where money is becoming devalued the fastest, will tend to have the highest velocity.

7)B. Though we can’t be certain because changes in velocity and real income also impact inflation, the country with the highest inflation rate is under most circumstances injecting money at the fastest rate.