Question

Suppose the price level reflects the number of dollars needed to buy a basket of goods containing one can of soda, one bag of chips, and one comic book. In year one, the basket costs $8.00. In year two, the price of the same basket is $7.00. From year one to year two, there is at an annual rate of . In year one, $40.00 will buy baskets, and in year two, $40.00 will buy baskets. This example illustrates that, as the price level falls, the value of money .

Answer 1

Answer: The answer is as follows:

Explanation:

Price of basket in year one = $8

Price of basket in year two = $7

So, from year one to year two there is a fall in the price level which means that there is deflation in the economy at an annual rate of :

$\frac{P_{2} -P _{1}}{P_{1} } \times 100$

= $\frac{7 - 8}{8} \times 100$

= -12.50%

In year one, $40 will buy $\frac{40}{8}$ = 5 Baskets

In year two, $40 will buy $\frac{40}{7}$ = 5.71 Baskets

Value of money = $\frac{1}{price\ level}$

Hence, this example illustrates that, as the price level falls, the value of money increases.