Question

Grab a blank sheet of paper and try some inflation analysis on your own. Take a picture or scan your sheet, and upload it after you are finished. This contributes to your participation grade in the class.

1. Because inflation increased by only 1.7% in 2008, the American Association of Retired Persons comments that this is “an unfortunate side effect of inflation, since Social Security payments, which are indexed to inflation, will increase by only 1.7% in 2008.” Comment on whether this is an “unfortunate side effect of inflation” or not.
2. The Federal Reserve Bank (Fed) can impact the economy through changes in the Federal funds rate, because changes in this interest rate will change all interest rates throughout the economy. The Federal funds rate was constant at 5.25% from 1996–1998, a time of falling inflation. What impact did this have on real interest rates during this time? What was likely to happen to investment spending?
3. “Traveling in Turkey is much cheaper now than it was 10 years ago,” says a friend. "Ten years ago, a dollar bought 1,000 lira; this year, a dollar buys 1,500 lira.” Total inflation over this period was 25% in the United States and 100% in Turkey. Is your friend right or wrong—has it become more or less expensive to travel in Turkey?

Answer 1

1.

No this is not an unfortunate side effect of inflation.

This is because social security payments are always adjusted for inflation. Higher the inflation, higher the social security payments by the same percentage. The purpose is to keep the real value of social security payments same. This means, in the given case when inflation is 1.7% , social security payments will also increase by 1.7%, keeping their real value unchanged. Thus, the retired are neither worse off nor better off in this arrangement. Thus, one cannot say this is an unfortunate side effect of inflation.

2.

Real interest rate = Nominal rate - Inflation

When inflation falls, real interest rate will increase.

As a result, during 1996-1998, real interest rate were rising.

Low inflation and high real interest rates lead to lower investment spending.

3.

No. The friend is wrong.

Although the value of dollar has increased, but so has inflation.

Inflation in Turkey = 100%

Inflation in US = 25%

Real change in value of dollar has reduced and it will now become more expensive to travel to Turkey, due to such inflation inflation in Turkey, relative to US