Suppose the price level reflects the number of dollars needed to buy a basket of goods containing one cup of tea, one biscuit, and one magazine. In year one, the basket costs $7.00. In year two, the price of the same basket is $8.00. From year one to year two, there isinflation at an annual rate of . In year one, $42.00 will buy baskets, and in year two, $42.00 will buy baskets. This example illustrates that, as the price level rises, the value of money .

14.3%

6 baskets

5.25

Falls

Explanation:

Inflation is a persistent rise in the general price levels

Types of inflation

1.demand pull inflation – this occurs when demand exceeds supply. When demand exceeds supply, prices rise

2.cost push inflation – this occurs when the cost of production increases. This leads to a reduction in supply. Higher prices are the resultant effect

Costs of inflation  

Shoe leather cost is when people try to spend money immediately so they would not be holding money for a long time. This is because money loses its value in an inflation.

Menu costs are the costs of changing price constantly as a result of inflation, When there is inflation, prices increases regularly. As a result prices needs to be updated regularly.

Annual rate of inflation = (0.08/0.07) - 1 = 0.143 = 14.3%

Baskets that can be bought in year 1 = 42 / 7 = 6

Baskets that can be bought in year 2 = 42 / 8 = 5.25

$42 buys less basket of goods in year 2. It means that the value of money has declined

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