Let’s consider the effects of inflation in an economy composed only of two people: Toto, a bean farmer, and Dorothy, a rice farmer. Toto and Dorothy both always consume equal amounts of rice and beans. In year 2009, the price of beans was €1, and the price of rice was €3.

a. Suppose that in 2010 the price of beans was €2 and the price of rice was €6. What was inflation?

Was Toto better off, worse off or unaffected by the changes in prices? What about Dorothy?

b. Now suppose that in 2010 the price of beans was €2 and the price of rice was €4. What was inflation? Was Toto better off, worse off or unaffected by the changes in prices? What about Dorothy?

c. Finally, suppose that in 2010 the price of beans was

€2 and the price of rice was €1.50. What was inflation?

Was Toto better off, worse off or unaffected by the changes in prices? What about Dorothy?

d. What matters more to Toto and Dorothy – the overall inflation rate or the relative price of rice and beans?