Question 1

Given a fixed nominal interest rate on a loan, unanticipated deflation:

Accepted Answer

Unanticipated deflation increases the real value of money, meaning that the amount of money borrowed now has more purchasing power in the future. This makes the real burden of repaying the loan heavier for the borrower, as they have to pay back more in terms of real goods and services than they initially borrowed.

Question 2

An unanticipated increase in inflation will:

Accepted Answer

An unanticipated increase in inflation will cause lenders to lose purchasing power as the value of the money they receive in repayment decreases. Borrowers, on the other hand, will benefit as the amount they owe remains fixed, but the value of the money they use to make repayments decreases. Therefore, an unanticipated increase in inflation will redistribute income from lenders to borrowers.

Question 3

If inflation had long been 4% and was therefore expected to continue, then it unexpectedly increased to 7% inflation:

Accepted Answer

When inflation increases unexpectedly from 4% to 7%, the real interest rate on loans issued just before the change would decrease. This is because the real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. If the nominal rate is fixed and inflation rises, the real interest rate falls.

Question 4

The nominal interest rate equals:

Accepted Answer

The answer of The nominal interest rate equals:
...

Question 5

Which of the following biases the CPI to underestimate increases in prices?

Accepted Answer

The Consumer Price Index (CPI) does not underestimate increases in prices due to the substitution bias, quality bias, or new outlet bias. Instead, these biases are known to potentially overstate the rate of inflation measured by the CPI, not underestimate it.

Question 6

Say that initially the nominal interest rate is 6% and prices are stable, but the inflation rate the following year rises to 3%. If the real rate of interest is to remain unchanged, the nominal interest rate in the second year must:

Accepted Answer

The real interest rate is the nominal interest rate minus the inflation rate. In this scenario, the real interest rate is initially 6% - 0% = 6%. If the inflation rate the following year rises to 3%, the real interest rate must remain unchanged at 6%.

To keep the real interest rate at 6%, the nominal interest rate in the second year must be the sum of the real interest rate (6%) and the new inflation rate (3%). Therefore, the nominal interest rate in the second year should rise by 3 percentage points (from 6% to 9%).

Option C) is therefore the correct answer.

Question 7

If the nominal interest rate is 6% and the inflation rate is 3%, the real interest rate is

Accepted Answer

The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. In this case, the real interest rate would be 3% (6% - 3% = 3%). Therefore, the best choice is B.

Question 8

Which of the following does not lead to the CPI underestimating increases in prices?

Accepted Answer

The housing bias does not lead to the CPI underestimating price increases. The other biases (substitution, quality, and new outlet) can cause the CPI to underestimate inflation by not fully capturing consumer behavior or improvements in product quality.

Question 9

If you were a borrower, which of the following unexpected changes in inflation would you prefer once you have taken out a long term fixed rate loan?

Accepted Answer

An increase in inflation benefits borrowers with fixed-rate loans because it reduces the real value of the money they have to repay. Among the options, moving from 2% to 6% inflation represents a significant decrease in the real value of repayments, making it the most favorable scenario for a borrower.

Question 10

If the nominal interest rate is 3% and the inflation rate is 6%, the real interest rate is

Accepted Answer

The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. Therefore, the real interest rate in this scenario would be 3% - 6% = -3%. This means that the purchasing power of an investment earning a nominal interest rate of 3% would actually decrease by 3% due to inflation, resulting in a negative real return of -3%.

Question 11

If you were a lender, which of the following unexpected changes in inflation would you prefer once you have issued a long term fixed rate loan?

Accepted Answer

As a lender, a decrease in inflation would be preferable as it would mean that the purchasing power of the money being repaid would be increasing over time. Option C is the best choice as it represents a significant decrease in inflation, which would result in a greater increase in the real value of the money being repaid than the other options. Additionally, the decrease in inflation from 14% to 8% is a more substantial change than the decrease from 6% to 3%, which is the only other option that represents a decrease in inflation. The increases in inflation in options A and B are both undesirable for a lender as it would mean that the real value of the money being repaid would be decreasing over time.

Question 12

The real interest rate equals:

Accepted Answer

The real interest rate is the nominal interest rate adjusted for inflation, thus it is calculated as the nominal interest rate minus the inflation rate.

Question 13

If the nominal rate of interest is 10.5 percent, and the inflation rate is 4.3 percent, what is the real rate of interest?

Accepted Answer

Real rate of interest = nominal rate of interest - inflation rate 
Real rate of interest = 10.5% - 4.3% 
Real rate of interest = 6.2%

Question 14

Given a fixed nominal interest rate on a loan, unanticipated inflation:

Accepted Answer

Unanticipated inflation decreases the real value of money, which means the actual value of the payments made to pay off the loan decreases, effectively reducing the burden of the loan for the borrower.

Question 15

What would happen to the real interest rate if originally the nominal interest rate was 14% and the inflation rate was 10%, then the nominal interest rate fell to 7% as the inflation rate fell to 4%? It would go from:

Accepted Answer

The real interest rate can be approximated by subtracting the inflation rate from the nominal interest rate. Initially, it's 14% - 10% = 4%. After the change, it's 7% - 4% = 3%.

Question 16

The costs imposed on a firm from changing listed prices is termed:

Accepted Answer

The term used for the costs incurred by a firm when changing the listed prices is called the menu cost of inflation. This cost includes the expenses involved in printing new menus, advertising new prices, and updating computer systems.

Question 17

Which of the following refers to extremely high rates of inflation for sustained periods of time?

Accepted Answer

Hyperinflation refers to extremely high rates of inflation for sustained periods of time. Deflation is the opposite of inflation and refers to a decrease in the general price level of goods and services. A bust is a term used in the business cycle to describe a period of economic decline following a boom. A depression is a severe and prolonged recession characterized by high unemployment, low economic activity, and a general sense of economic hardship.

Question 18

If the real interest rate is 3% and the inflation rate is 6%, the nominal interest rate is

Accepted Answer

The nominal interest rate is derived by adding the real interest rate and the inflation rate. Therefore, nominal interest rate = real interest rate + inflation rate
= 3% + 6%
= 9%.
Hence, the correct answer is C) 9%.

Question 19

If inflation had long been 7% and was therefore expected to continue, then it unexpectedly increased to 4% inflation:

Accepted Answer

If inflation had long been at 7%, lenders would have set their nominal interest rates accordingly to cover the expected inflation rate. So, a loan issued just before the change occurred would have a higher nominal interest rate than the new inflation rate of 4%. Therefore, the real interest rate (nominal interest rate minus inflation rate) on loans issued just before the change occurred would increase by three percentage points.

Question 20

The difference between the nominal interest rate and the rate of inflation is:

Accepted Answer

The difference between the nominal interest rate and the rate of inflation is known as the real interest rate. This is because it reflects the actual purchasing power gained or lost by an investment after accounting for inflation. The prime rate, discount rate, and coupon rate are all specific interest rates used in different contexts, but they do not directly relate to the difference between nominal interest rates and inflation.

Quiz 10: Consumer Choice Theory