Question

1. Identify and briefly describe the problems that always arise from measuring price levels with a fixed basket of goods. Tip: They are discussed in the book chapter (30%) 

2. The president of Syldavia declares on national television “We will raise the minimum wage by 50% to combat inflation”. Do you agree with her solution? Why? Explain your reasons using economic concepts discussed in class material. Minimum 150 words (30%)

Answer 1

Answer 1)

There are three types of problems arise when we measure price levels with fixed basket of goods

A) substitution

The main issue is that the basket is fixed and in reality consumers basket are not fixed so they change their basket when something relatively more expensive or relatively cheaper.if you have a fixed basket then you missed this idea that consumer lower their cost by switching over to relatively cheaper items.

B) introduction of new goods

If the basket fixed so it doesn't allow for the introduction of new good . The introduction of new goods increases the variety, allows consumers to find products that more closely meet their needs. Thus CPI overstates increases cost of living.

C) unmeasured quality change

The quality change of an item that is missing. Let's take an example if a smartphone today might be $1000 where smartphone five years ago might have been $500 so it may look like it's a lot more expensive to live today than it was five years ago . But the quality of item has improved ,better cameras , Better function etc. So it doesn't measure the quality change. The BLS tries to account for quality changes but probably miss some, as quality is hard to measure

Answer 2)

The raising minimum wage doesn't principally effect inflation, first is that the wages are typically a very small part of the operating cost of a business. But that obviously varies from business to business and in the service industry the wages are much higher percentage of product cost. As a result to give more wages employer must increase the price for goods and services it creates wage push inflation. The other reason why increasing the minimum wage doesn't affect inflation because inflation happens when too many dollars chasing too few goods and services. when you increase minimum wage it increases the purchasing power of consumers and more money circulation in the market, this also might cause inflation because situation is as it was