Question

38. Assume a simple economy that produces only 3 goods.  

    In the base year: 4 units of books sold at a price of $10, 4 units of clothing sold at a price of $5, and 20 units of food sold at a price of $2.  
    In the current year: 6 units of books sold at a price of $8, 2 units of clothing sold at a price of $7, and 15 units of food sold at a price of $3.

        Calculate the Laspeyres price index (weight by base year quantities) for the current year.
  
                


39. What is the purpose of a COLA clause?   
     
          To keep nominal income constant
          To keep real income constant
          To prevent a fall in the purchasing power of the dollar
          To prevent hyperinflation
          To protect against changes in the exchange rate



40. Assuming there is expected to be inflation over the coming year, will a 1-year TIPS (Treasury inflation protected security) offer a higher or lower interest rate than a comparable non-TIPS Treasury security?   
     
          Higher
          Lower
          Rates will be the same

Answer 1

Answer 38:

Laspeyres Price Index for current year

= Current cost of base year basket/ Base year cost of base year basket

= 8*4+7*4+3*20/ 10*4+5*4+20*2 *100

= 32+28+60/40+20+40 *100

= 120/ 100*100

= 120

Answer 2:

OPTION B: To keep the real income constant

Reason: COLA clause leads to increase in wages in accordance with increase in cost of living such that purchasing power is not affected. In other words, the real income remains constant, that is the main idea behind it.

Answer 3:

OPTION A: Higher

Reason: The yield of a TIPS also increase when inflation increases or is likely to increase, because higher rates bring down inflation. Because this will force people to keep their money deposited and there will be contraction of money supply in the economy, thus lowering inlfation.