Reading 15 Questions （HELP）

CFA Level I Economics
#1

There are 3 questions in the Practice probems that I don’t quite understand and would greatly appreciate it if anyone could shed some light on:

23 The least likely consequence of a period of hyperinflation is the:

A reduced velocity of money.

B increased supply of money.

C possibility of social unrest.

While I understand the correct answer is A, I think B is also unlikely: increased money supply is a cause of hyperinflation, not a consequence. Is it correct?

32 What is the most important effect of labor productivity in a cost- push inflation scenario?

A Rising productivity indicates a strong economy and a bias towards inflation.

B The productivity level determines the economy’s status relative to its “natural rate of unemployment.”

C As productivity growth proportionately exceeds wage increases, product price increases are less likely.

The correct answer is C. My understanding is Cost-push inflation is caused by rising wages (one reason among others), how does it relate to answer C?

34 A product is part of a price index based on a fixed consumption basket. If, over time, the product’s quality improves while its price stays constant, the measured

inflation rate is most likely:

A unaffected.

B biased upward.

C biased downward.

The correct answer is B.

My understanding is if the price goes up, the index calculated shall be biased upward as the quality also improves, so "inflation” cannot be the scapegoat as the price goes up due to a legitimate reason. **

But what if the price stays constant while quality improves? How come it’s also biased upward? Shouldn’t it be “unaffected” ?**

Thank you very much in advance!

#2

Increase in money supply can be both the cause (i.e. the trigger) and also consequence (i.e. what happens after that), like a vicious cycle.

Page 224

During hyperinflation, people are eager to change their cash into real goods because prices are rising very fast. As a result, money changes hands at extremely high frequency. The government also has to print more money to support its increased spending.

This is true if wages increases faster than productivity growth.

But let’s say productivity growth proportionately exceeds wage increases:

Let’s assume for one worker, his wages is $50 per day and he produces 20 units per day (unit labor cost = $50/20 = $2.50 per unit). If his productivity growth say is +30% and wage increases is +10%, then his wages will increase to $55 and he now produces 26 units (unit labor cost is now $55/26 = $2.11 per unit). The unit labor cost declines when productivity growth proportionately exceeds wage increases, so the business is not forced to increase prices, hence no cost-push inflation.

#3

When the price index increases, it can be due to improvement in quality or simply price inflation. If we did adjust for quality improvement (using hedonic pricing), the price index would have been lower (i.e. lower inflation rate), hence the measured inflation rate (i.e. percentage change in price index) is biased upward.

#4

Again thank you so much Fino! The examples are excellent! I now become much clear about the answers and your explanations helped me deepen my understanding about the concetps! Much appreciated!

#5

I’m now a bit confused about the question: when it states the price stays constant, does it mean the price remains the same？
For example, the price of a watch was $100 in year 1, and still is $100 in year 2? So when calculating index, $100 is the price used? When the textbook explains why it’s biased upward, it’s based on the scenario of $100 in year 1, and maybe $130 in year 2 due to improved quality, so $130 is not all caused by inflation, if I understand this correctly?

My confusion is why the index is still biased upward if the price remains $100?

Thank you for taking the time to help me out!!

#6

Yes, the question is implying the price stays constant, like $100 per unit now and in the next 1 year (say).

Let’s say the basket contains two items, X and Y:

Item X:
Price at time 0 = $50
Price at time 1 = $70
Quantity at time 0 = 60

Item Y:
Price at time 0 = $100
Price at time 1 = $100
Quantity at time 0 = 40

The price index below are all based on Laspeyres price index.

Price Index at Time 0 = 100 (Starting index level)

Price Index at Time 1 = \frac{60 \times \$70 + 40 \times \$100}{60 \times \$50 + 40 \times \$100} \times 100

Price Index at Time 1 = \frac{8,200}{7000} \times 100 = 117.14

Inflation rate = \frac{117.14 - 100}{100} \times 100\% = 17.14\%

Now, let’s assume that over that 1 period, the quality of item Y improved but the price still remain constant at $100. Using a hedonic pricing model to adjust for the quality effect/bias, the adjusted price of item Y at time 1 is $97 (i.e. this is the price if the quality was the same as at time 0).

Re-calculating the price index and inflation rate, we get:

Price Index at Time 1 = \frac{60 \times \$70 + 40 \times \$90}{60 \times \$50 + 40 \times \$100} \times 100

Price Index at Time 1 = \frac{7,800}{7000} \times 100 = 111.43

Inflation rate = \frac{111.43 - 100}{100} \times 100\% = 11.43\%

It’s a very crude example, but what I’m trying to show is, if we did not remove the quality improvement effect, the price index would be higher, hence a higher inflation rate (i.e. upward biased) compared to the case where there was no quality improvement.

#7

Hi Fino!

Thank you very much for spending time in explaining this in such great details!

If you don’t mind me asking, how did you arrive at the price of $97 after adjustment?

Based on the adjusted price of $97 of Item Y in year 1, I thouhgt the calculation shall be:

Is there anything I missed?

Also I have an irrelevant question: the Laspeyres index calculation has an upward biased result; what about the Paasche index?

Sorry for my slowness！

#8

Just an example, actually, but the general idea is if we remove the quality improvement, the price should be lower (than $100 in this case).

Oh yes, my bad. It should be $97 instead of $90. Was rushing for my supper :scream:

You don’t have this problem with Paasche price index. But with Paasche index, the latest consumption (quantity) is not always available immediately for index computation.