Question

5. Problems and Applications Q5

Consider the effects of inflation in an economy composed of only two people: Manuel, a bean farmer, and Poornima, a rice farmer. Manuel and Poornima both always consume equal amounts of rice and beans. In 2019 the price of beans was $5, and the price of rice was $3.

Suppose that in 2020 the price of beans was $10 and the price of rice was $6.

Inflation was

.

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

	Better Off	Worse Off	Unaffected
Manuel
Poornima

Now suppose that in 2020 the price of beans was $7.50 and the price of rice was $6.

In this case, inflation was

.

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

	Better Off	Worse Off	Unaffected
Manuel
Poornima

Now suppose that in 2020, the price of beans was $1.50 and the price of rice was $6.

In this case, inflation was

.

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

	Better Off	Worse Off	Unaffected
Manuel
Poornima

What matters more to Manuel and Poornima?

The relative price of rice and beans

The overall inflation rate

Answer 1

Answer (1) Suppose that in 2020 the price of beans was $10 and the price of rice was $6.

Manuel and Poornima both will be unaffected as prices of beans and rice doubled. Both will spend income in purchasing rice and beans respectively. All income will be utilised. Hence both will be unaffected by changes in prices.

Now suppose that in 2020 the price of beans was $7.50 and the price of rice was $6.

Manuel will be worse off and Poornima will be better off. As Manuel will get rice for doubled price that is (100% ) but Poornima will get beans for $7.5 which is 50% more but less price as compare to Manuel.

Now suppose that in 2020, the price of beans was $1.50 and the price of rice was $6.

Manuel will be worsen off but Poornima will be better off.  

As now Manuel will get rice at double price but Poornima will get beans at half price. Hence Manuel will be worsen off but Poornima will be better off.

The overall inflation rate matters because overall inflation is decided by relative prices of rice and beans. This ultimately decide that which person is better off or worsen off or unaffected by changes in prices.

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