1.The following table shows the prices and the quantities consumed inthe country known as the University States. Suppose the base year is2003. This is the year the typical consumption basket was determinedso the quantities consumed during 2003 are the only quantities neededto calculate the CPI in every year.

YEARPRICEQUANTITYPRICEQUANTITYPRICEQUANTITY

OF BOOKSOF BOOKSOF PENCILSOF PENCILS OF PENSOF PENS

2003$ 5010$ 1100$5100

2004$ 5012$1200$1050

2005$6012$1.50250$2020

a.What is the value of the CPI in 2003?

b.What is the value of the CPI in 2004?

c.What is the value of the CPI in 2005?

d.What is the inflation rate in 2004?

e.What is the inflation rate in 2005?

f. What type of bias do you observe in the CPI and correspondinginflation rates you generated above? Explain.

g.If you had a clause in your wage contract that increased your wage bythe rate of inflation as measured by the CPI calculated above, wouldyour standard of living increase, decrease, or stay the same over theyears 2003-2005? Why?

h.Again, suppose you had a clause in your wage contract that increasedyour wage by the rate of inflation as measured by the CPI calculatedabove. If you personally only consume pens (no paper or pencils),would your standard of living increase, decrease, or stay the same overthe years 2003-2005? Why?

2.Suppose that you lend your rom mate $100 for one year at 9 per centnominal interest.

a.How many dollars of interest will your room mate pay you at the end ofthe year?

b.Suppose at the time you both agreed to the terms of the loan, you both expected the inflation rate to be 5 per cent during the year of the loan.What do you both expect the real interest rate to be on the loan?

c.Suppose at the end of the year, you are surprised to discover that theactual inflation rate over the year was 8 per cent. What was the actualreal interest rate generated by this loan?

d.In the case described above, actual inflation turned out to be higherthan expected. Which of the two of you had the unexpected gain orloss? Your room mate (the borrower), or you (the lender)? Why?

e.What would the real interest rate on the loan have been if the actualinflation rate had turned out to be 11 per cent?