Consider the effects of inflation in an economy composed of only two people: Larry, a bean farmer, and Megan, a rice farmer. Larry and Megan both always consume equal amounts of rice and beans. In 2016 the price of beans was $1, and the price of rice was $4. Suppose that in 2017 the price of beans was $2 and the price of rice was $8.
Inflation was.
Indicate whether Larry and Megan were better off, worse off, or unaffected by the changes in prices.
Better Off
Worse Off
Unaffected
Larry
Megan
Now suppose that in 2017 the price of beans was $2 and the price of rice was $4.80.
In this case, inflation was.
Indicate whether Larry and Megan were better off, worse off, or unaffected by the changes in prices.
Better Off
Worse Off
Unaffected
Larry
Megan
Now suppose that in 2017, the price of beans was $2 and the price of rice was $1.60.
In this case, inflation was.
Indicate whether Larry and Megan were better off, worse off, or unaffected by the changes in prices.
Better Off
Worse Off
Unaffected
Larry
Megan
What matters more to Larry and Megan?
The relative price of rice and beans
The overall inflation rate

a.  

Inflation = (2017 price of basket - 2016 price of basket) / 2016 price of basket

2016 price of basket = 1 + 4 = $5

2017  price of basket = 2 + 8 = 10

Inflation

= (10 - 5) / 5

= 100%

Both Megan and Larry would be unaffected by the changes in prices because the prices doubled for both of them.

b. Now suppose that in 2017 the price of beans was $2 and the price of rice was $4.80.  

Market basket in 2017 = 2 + 4.8 = $6.80  

Inflation

= (6.8 - 5) / 5

= 36%

Larry will be better off because the price of beans increased by 100% which is more than the inflation rate of 36%.

Megan's price increase = (4.8 - 4)/4 = 20%.

Inflation is 36%.

Megan will be worse off as inflation is higher than the increase in price of rice.

c. Now suppose that in 2017, the price of beans was $2 and the price of rice was $1.60.  

Market Basket in 2017 = 2 + 1.6 = $3.60  

Inflation = (3.6 - 5)/5 = -28%

Larry will be better off because his prices have risen while general inflation has fallen.  

Megan's price decrease = ( 1.6 - 4)/4 = -60%. Inflation was -28%.

Megan will be worse off because inflation decreased less than her prices did.

d. What matters more to Larry and Megan?

The relative price of rice and beans

This matters more to them because a change in prices of the commodities they sell could either benefit them or give them a loss regardless of the inflation rate.

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