3. Differentiate between the nominal rate of interest and the real rate of interest.

RESPONSE:

ANSWER: The nominal interest rate is the interest rate as usually reported without a correction

for the effects of inflation. The real interest rate is the interest rate corrected for the effects of inflation. The real interest rate = nominal interest rate minus the inflation rate.

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4. What is meant by the inflation rate? If the CPI in 1996 was 107.6 and in 1995 was 10

5.9, calculate

the inflation rate for 1996.

RESPONSE:

ANSWER: The inflation rate is the percentage change in the price index from the preceding

period. The inflation rate for 1996 would be:

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5. What are the problems associated with using the consumer price index to measure the cost of living?

RESPONSE:

ANSWER: The problems are: (1) Prices do not change proportionately. Consumers respond by

buying less of the goods whose prices have risen by large amounts and by buying more of the goods whose price have risen by less, or even fallen. The index is computed using a fixed basket of items, so theses changes in quantity would not be reflected in the basket. This is referred to as the substitution bias.

(2) The CPI is developed using a fixed basket of goods and services, when new products are introduced during the time period that a particular fixed basket is being used, these new products will not be included in calculation of the index. (3) The CPI does not measure quality changes. If the quality of a good deteriorates from one year to the next, the value of the dollar falls, even if the price of the good stays the same. Likewise, if the quality of the good increases from one year to the next, the value of a dollar also rises. Statistics Canada will try to adjust the price of the good to account for the quality change, but it is very difficult to measure quality.

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CHAPTER 25: PRODUCTION AND GROWTH

True/False

Indicate whether the statement is true or false.