Suppose the price level reflects the number of dollars needed to buy a basket of goods containing one cup of coffee, one donut, and one newspaper. 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 (Deflaton, Inflation) 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:

From year one to year two, there is (Deflation,Inflation) at an annual rate of _12.5%. In year one, $40.00 will buy 5 baskets, and in year two, $40.00 will buy ___5.7 (6) baskets. This example illustrates that, as the price level falls, the value of money:_increases___

Explanation:

a) Data and Calculations:

The price of a basket of goods in year one = $8.00

The price of the same basket of goods in year two = $7.00

Difference in price (reduction in price) = $1 ($8 - $7)

Percentage reduction in price = $1/$8 * 100 = 12.5%

With $40/8, 5 baskets were bought

With $40/7, 5.7 baskets will be bought

b) Economists are always wary of prolonged deflation or continuous general falling prices of goods because it depicts an economy that is seriously weakening at its foundation.  As a fallout, companies slow production, reduce output, lay off workers, and reduce salaries (earned income).

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