Question

2 . Problems 22-5

Consider the effects of inflation in an economy composed of only two people: Van, a bean farmer, and Amy, a rice farmer. Van and Amy 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 Van and Amy were better off, worse off, or unaffected by the changes in prices.

	Better Off	Worse Off	Unaffected
Van
Amy

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 Van and Amy were better off, worse off, or unaffected by the changes in prices.

	Better Off	Worse Off	Unaffected
Van
Amy

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 Van and Amy were better off, worse off, or unaffected by the changes in prices.

	Better Off	Worse Off	Unaffected
Van
Amy

What matters more to Van and Amy?

O The relative price of rice and beans

O The overall inflation rate

Answer 1

2. In this case, we can consider 2016 as the base year and 2017 as the current year. In the base year or 2016, the price of beans and rice were $5 and $3 respectively and in 2017 the price of beans and rice increased to $10 and $6 respectively. Now, based on the information provided in the question, let's suppose that both Van and Amy always 1 unit of beans and 1 unit of rice. Therefore, the total cost of consumption basket of both Van and Amy in the base year or 2016=($5*1 unit of beans)+($3*1 unit of rice)=$8 and the total cost of consumption basket for both consumers in 2017=($10*1 unit of beans)+($6*1)=$16. Hence, the inflation rate in 2017 was={($16-$8)/$8}*100=100% or 1. Note that the increase in the overall price level of the goods or commodities in the economy by 100% makes both Van and Amy worse off compared to before as their real purchasing power has now decreased accordingly or proportionately, considering both of their nominal income level as constant or unchanged.

Now, the price of beans and rice in 2017 became $7.50 and $6 respectively and the price of both goods remains the same in 2016. Therefore, the total cost of the consumption basket of both Van and Amy in 2017 would now become=($7.50* 1 unit of beans)+($6*1 unit of rice)=$13.50. Thus, the rate of inflation in 2017 now becomes={($13.50-$8)/$8}*100=68.75% or 0.6875. The inflation rate in 2017 now becomes 68.75% and considering the nominal income of both Van and Amy as constant or unchanged again, the real purchasing power of both consumers decreases making them worse off from a general standpoint.

In this instance, the price of beans in 2017 drops to $1.50 compared to its price in 2016 and the price of rice was $6. The respective price of beans and rice in 2016 remains the same or unchanged. Hence, the total cost of consumption basketfor both Van and Amy now becomes=($1.50*1)+($6*1)=$7.50. Therefore, the inflation rate in 2017 now becomes={($7.50-$8)/$8}*100=-6.25% or 0.0625. In this case, the price level of the goods or the inflation rate in the economy has actually dropped causing a deflationary effect implying that now both Van and Amy are actually better off as their real purchasing power has increased froman overall perspective, considering a constant or unchanged nominal income of both the consumers.

As both Van and Amy consume or purchase both beans and rice in equal quantity, the individual utility or satisfaction obtained from consuming or purchasing each unit of both rice and beans by both the consumers is same and hence, they would be indifferent about changing the substitution rate of the consumption of both goods, holding everything else constant. Therefore, both the consumers, in this case, would be relatively more concerned about the total expenditure or cost of their respective consumption baskets which is affected by the changes in the inflation rate in the economy, given a particular level of nominal income of both the consumers. Hence, the changes in the overall inflation rate would impact the real purchasing power of the consumers based on their respective nominal income level thereby affecting the overall or total utility or satisfaction level of both the consumers obtained from consuming both beans and rice.