Question

Consider the effects of inflation in an economy composed of only two people: Rajiv, a bean farmer, and Simone, a rice farmer. Rajiv and Simone both always consume equal amounts of rice and beans. In 2016 the price of beans was $5, and the price of rice was $3.

Suppose that in 2017 the price of beans was $10 and the price of rice was $6.

Inflation was ________%

.

Indicate whether Rajiv and Simone were better off, worse off, or unaffected by the changes in prices.

	Better Off	Worse Off	Unaffected
Rajiv
Simone

Now suppose that in 2017 the price of beans was $7.50 and the price of rice was $6.

In this case, inflation was __________%

.

Indicate whether Rajiv and Simone were better off, worse off, or unaffected by the changes in prices.

	Better Off	Worse Off	Unaffected
Rajiv
Simone

Now suppose that in 2017, the price of beans was $1.50 and the price of rice was $6.

In this case, inflation was ___________%

.

Indicate whether Rajiv and Simone were better off, worse off, or unaffected by the changes in prices.

	Better Off	Worse Off	Unaffected
Rajiv
Simone

What matters more to Rajiv and Simone?

The overall inflation rate OR The relative price of rice and beans

Answer 1

a.) Let us suppose that Rajiv, bean farmer and Simone, rice farmer consume one unit of bean and one unit of rice. In 2016, the price of bean was $5 and price of rice was $3. In 2017, the price of bean increased to $10 and price of rice increased to $6. The market basket in 2016 was $5+$3= $8. The market basket in 2017 was $10 +$6=$16. Thus, the rate of inflation is ($16 − $8)/$8 × 100% = 100%. Neither farmer is affected by the change in price. Because prices of the goods increased by 100% and so did the incomes of the farmers.

b)     When price of bean was $7.50 and price of rice was $6. The market basket is $7.50+$6=$13.50. Rate of inflation is    ($13.50-$8)/8=$5.50/8=68.75%. Simone is better off since her income increases by 100% but the inflation rose only by 68.75%. Rajiv is worse off because his income increased by only 50% ($7.50-$5)/$5, whereas, inflation rose by 68.75%

c)    When price of bean was $1.50 and price of rice was $6.00. The market basket is $1.50+$6=$7.50. Rate of inflation is ($7.50-$8)/8=-$0.5/8=-6.25%. Simone is better off since her income increases by 100% but overall prices fell by 6.25%. Rajiv is worse off because his income fell by ($1.50-$5)/$5 =(3.50/5)x100=70%, whereas, overall prices fell by 6.25%.

d.) The relative price of rice and beans matters more to Hubert and Kate than the overall inflation rate.