Economics 304Homework #1â A ride into reality!Instructions: Please show all work or points will be taken
off. Good luck!1. (60 points total â 10 points each part) In this first
homework assignment, we are getting our âhands dirtyâ to get familiar with some
of the major macroeconomic variables that we will be using and working with
throughout the semester. Our first chapter with âsomething to sink our teeth
intoâ is chapter 3 and it is all about the factors of production, the labor
market, and of course, the production function. Major variables in this part of
the macroeconomy (i.e., the supply side of the economy) include, but certainly
are not limited to, employment (denoted N), real wages (denoted w = W/P where W
= nominal wage and P is the price index – typically the CPI) and real GDP
(denoted Y). When we move to chapter 4 we encounter many more major
macroeconomic variables including consumption (C), investment (I), and the real
interest rate (denoted r), among others. We are going to use FRED as our source
of data (many professional economists use this site, nice clean data!)[1]I provide you with the links to the data that is needed
throughout this assignment. For an interesting look at the %?W vs. the %?P,
click Use the following two links to answer the following
questions:For Nominal Wages (W) Price index CPI (P) I recall back in the early 1990s (before many of you were
born!) when Bill Clinton was running for President and he was arguing that
under the Bush Sr. Administration (1989-1992) that real wages for Americans
actually fell implying that on average, workers were better off (in terms of
the real wage) at the beginning of the Bush Administration compared to the end
of the Bush Administration.a) Calculate the real wage (W/P) the first month of the Bush
Sr. Administration (1/89) and compare it to the last month of the Bush Sr.
Administration (12/92). Please show all work. Was Bill Clinton correct in his
claim? Why or why not?b) The last four years of the Clinton Administration were
arguably the absolute best in terms of the recent performance of the US economy
(1/97 – 12/00). When we get to Chapter 3, we will discuss this period in much
more detail and we refer to this period as the “new economy.” Of
course one metric of the health of any economy is the behavior of the real
wage. In this part, we repeat the analysis above but use the final four years
of the Clinton Administration. In particular, calculate the real wage (W/P) the
first month of Clinton’s second term (1/97) and compare it to the last month of
Clinton’s second term(12/00). Did real wages rise or fall during this period?
Please show all work.c) Now do the same with the Obama Administration. That is,
calculate the real wage at the begining of the Obama Aministration (1/2009) and
compare it to the present real wage (use the most recent available data).d) When I used to fish in Miami, say June of 2001, I used to
tip the captain and mate $30. Calculate the tip that I would need to give the
captain and mate 1) 10 years prior (June of 1991) and 10 years hence (June of
2011) that would have the same purchasing power as my tip in June 2001. In other
words, calculate the tips that I would need to give the captain and mate so
that they can achieve the same level as satisfaction as in June 2001 (assume
importantly that the basket they consume is same as the CPI basket).e) Using the most recent data, calculate the percent change
in the real wage over the most recent 12 months in two different ways. First,
calculate the real wage one year ago and now and take the percent change of
those two numbers. Second, use the approximation as we used in class…%?(W/P)
= %?W – %?P. That is, take the percent change in nominal wages and subtract the
percent change in prices (aka inflation). Now compare your two answers, is the
approximation close to the real deal?To answer f) you need to use the following link:Employment (N) f) Draw a graph with the real wage (w=W/P) on the vertical
axis and employment (N) on the horizontal axis. Locate the initial conditions
(calculate the real wage when you were born as well as the number employed) as
point A and the conditions as of the present as point B. Use actual numbers and
label your points accordingly. Your graph should have two points and no lines.
How many more people are working now relative to when you were born (hint, the
answer is in millions)?2. (70 POINTS total – 10 points each part) Another
critically important real economic variable we consider in this homework
assignment is the real interest rate. We learned that the real interest rate is
the difference between nominal interest rates and inflation. In fact, there are
two real interest rates: ex-ante and ex-post. Ex-ante real interest rates are
the expected real rates where ex-post real interest rates are the real rates
that were actually realized. An example will help. Suppose one year nominal
interest rates are 5% and you expect that prices are going to rise by 3% (i.e.,
your expected rate of inflation (?e) is 3%) over the holding period = one year.
Your ex-ante or expected real rate of interest is therefore 2%. Now suppose that
over the year inflation wasnât 3% but 4% instead (your expectation rate of
inflation was wrong). That is, actual inflation (?) equaled 4% and thus your
actual real rate, referred to as the ex-post real rate of interest is only 1%.
Naturally, ex-ante and ex-post real interest rates differ anytime expectations
of inflation are different than the actual rate of inflation. To summarize, the
ex-ante real rate is equal to iâ?e where the ex-post real rate is equal to iâ?.
In general, it is the ex-ante rate that is most important since we base
decisions today, in part, on expectations of the future (decision making under
uncertainty!!!!).In this problem. we are going to calculate real interest
rates, both ex-post and ex-ante. The data you need for this problem are given
below:Nominal one year rates (i) Price index CPI (P) Expected Inflation A couple notes are in order.i) Expected inflation data is one year hence – so for
example, expected inflation for the period from July 2010 to July 2011 is given
in July 2010 and if you view the data, the expected inflation during this time
is 2.7% =?e.ii) To calculate the actual rate of inflation, for example,
during the July 2010 to July 2011 period you need to take the percent change in
P = %? P. Using the CPI data, we have theprice index equaling 217.6 in 7/2010 (beginning of August
given the end of month data) and 225.4 in 7/2011 (end of July, 2011). Note,
this is a 12 month period. The actual rate of inflation during this time is
3.58% =?iii) When using the one year nominal interest rate to
calculate the all important real rate(s) of interest we need to be careful. For
example, using the same one year time period (July 2010 – July 2011) we simply
use the one year rate given as of July 2010. Think of buying the bond in July
2010, putting it in a safety deposit box (or under your mattress, a coffee can,
etc.) and then cashing it in when it matures in July 2011 (you get your
principal times whatever the nominal interest rate is). In viewing the data,
the one year rate in July 2010 is 0.29%. So clearly (and by design of the Fed),
both the ex-ante and ex-post real rates are negative during this period and
differ because expected inflation was not equal to actual inflation.2 a) Calculate the ex-ante and ex-post real rate of interest
between July 2008 and July 2009. Why are these real rates so different? Again,
please show all work.b) We know that most decisions are in part, based on
expectations of the future. Suppose we have two people who are trying to decide
whether to consume today (August 2008) or save for the future and consume one
year later, in August 2009. One person, let’s call him Joe, is basing their
decision on the ex-ante real rate of interest like most of us do. The other
person who has a crystal ball, we’ll call her Crystal, can see exactly what the
actual rate of inflation is going to be and thus, has perfect foresight and
bases their decision on the ex-post real rate. Given the difference in the
ex-ante and ex-post real rates above, who would be more likely to save and who
would be more likely to spend? Explain in detail and feel free to use the
shopping cart example we used in class.c) Given the most recent data, what is the ex-ante one year
real rate of interest? Is this higher or lower than the ex-post real rate of
interest or don’t we know? Explain.We discussed the evils of deflation.d) From a macroeconomic perspective, why is deflation so
bad? Please refer to consumer behavior and the corresponding behavior of firms
in a deflationary environment.e) Now discuss the fact that deflation is the central bank’s
worst nightmare. Make sure you refer to either the ex-post or ex-ante real rate
that you calculated above, whichever applies. Why is this environment such a
nightmare for the central bank and monetary policy? Explain using the Fisher
equation for the real rate of interest.f) Suppose Joe, from part b) above, changes his expectation
of inflation to equal the actual rate of inflation that occurred between July
2008 and July 2009. What is the lowest the ex-ante interest rate can go, given
the change in Joe’s inflationary expectations. Click Here for a hint!g) Given a deflationary environment, what can the central
bank do to rid themselves of the nightmare? Explain. ClickHere for a hint!
Explain why this move is supposed to work in terms getting rid of the
nightmare.3. (50 points total â 10 points each part) Real vs nominal
GDP. When we get to chapter three we consider a production function where the
output of all our factors of production is of course real GDP. Recall that
Nominal GDP is the total value of goods and services produced at current prices
where real GDP is the total value of goods and services expressed in constant
prices (we deflate nominal GDP by a price index called the GDP deflator). The
links for the data used in this problem are below.Nominal GDP GDPGDP Deflator (P) GDPCTPIa) Let us examine the so-called “Great Recession”
that occurred from December 2007 (fourth quarter since data on GDP and the GDP
deflator are quarterly) to June 2009 (second quarter). Clickhere for the NBER
site. Calculate the percent change in real GDP by calculating real GDP at the
beginning of the recession as well as calculating real GDP at the end of the
recession and then, take the percent change. Please show all work. (for all
calculations use the data from 2007-10-01 to 2009-04-01.)b) Let us go back to the 1973â 1975 recession. Note that
officially, this recession began in fourth quarter of 1973 and ended in the
first quarter of 1975. Calculate the percent change in real GDP in the same
manner as you did above in point a) (for all calculations use the data from
1973-10-01 to 1975-01-01 (GDP data is quarterly).c) Now calculate the percent change in the GDP price
deflator (P) during this 1973 – 1975 recession.d) What is this period often referred to and why (starts
with S!)?e) Finally, draw a graph with the general price level on the
vertical axis (the GDP deflator) and real GDP on the horizontal axis. Label the
initial point (the beginning of recession) as point A and the end point (the
end of recession) as point B. Be sure to label graph completely using the
specific numbers you calculated above.[1] FRED stands for Federal Reserve Economic Data.-
clickHere for the FRED website
[2] Hint, when deflating using a price index, we typically
move the decimal two place to the left. For example, in 12/09 W = $18.80 and
the price index was 217.541. The real wage is thus 18.80 divided by 2.17541.
