Question

a. A house is worth $400,000 in 2020, but was worth $150,000 in 1990. Using prices in 1990 as the base year, know that prices in the economy have grown on average by 1.50 times between 1990 and 2020.

(i) If the price of the house had risen at the same rate as average prices, what would the house be worth in 2020? Briefly explain your answer.

(ii) Without doing any calculations, but simply based on information in the question and your response in (i), would you be better off having bought this house in 1990 or 2020? Briefly justify your answer.

(iii) Calculate the rate of inflation between 1990 and 2020.

b. Assume wage negotiations are done and agreed based on the CPI. Briefly explain what happens to employers and employees when the CPI is upwardly biased (i.e. the CPI is estimated to be higher than what it should be).

Answer 1

a. A house is worth $400,000 in 2020 and $150,000 in 1990. Taking 1990 as the base year, prices have grown on average by 1.50 times between 1990 and 2020.

(i) Now if the price of the house had risen at the same rate as average prices, it would have risen by 1.5 times between 1990 and 2020 to reach a price of 150000*1.5 = $225,000 in 2020.

(ii) We would be better off having bought this house in 1990 because now the growth rate of the value of this house is greater than the growth rate of prices / inflation. Hence real value of house has risen.

(iii) The rate of inflation between 1990 and 2020 is (150 - 100)/100 = 50%. This is because prices have grown on average by 1.50 times between 1990 and 2020. This implies that the base year index of 100 should be 150 in 2020.

b. When the CPI is upwardly biased or that the CPI is estimated to be higher than what it should be, it is beneficial for employers because they are paying a lower real wages. Workers are at a loss because now they are receiving nominal wages that has a lower purchasing power (which again means their real wage rate has fallen).