ECO 304 Homework Assignment

1. (80 points total1- 10 points each part) In this first homework assignment, we are getting our 'hands dirty' 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 'something to sink our teeth into' 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 ofthe 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 Pis the price index-typically the CPI) and real GDP (denoted Y). When we move to chapter 4 we encounter many more major macroeconomic variables includingconsumption (C), investment (1), 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!)
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 Here.As we move forward through the class, we are going to learn about some "business cycle facts." See page 290 in text, Chapter 8. In this first question, among other things, we are going to investigate the behavior of the real wage over the most recent business cycle. (Click Here for the NBER site -look at right hand side of page for the official dates of the most previous 4 recessions). In particular, we are going to calculate the percentchange in the real wage during the most recent recession (12/07-6/09) and compare it to the percent change during the most recent recovery, 7/09 to the present.Use the following two links to answer the following questions:For Nominal Wages \W)Price index CPI (P)Click HereClick Herea) Calculate the real wage (W/P) the first month of the recession 12/07 and compare it to the last month of the recession 6/09. What is the percent change in the real wage during this most recent recession?
b) Using the expression above, re-calculate the percent change in the real wage during the most recent recession (12/07-6/09) and compare to your answer in part 1a). Does the expression above serve as a good approximation (i.e., is your answer similar to your answer in part a)? Please show all work.
c) Now calculate the real wage during the first month of the recovery, 7/09 and compare it to the real wage according to the most recent data. What is the percent change in the real wage during this recovery thus far?
d) According to the business cycle facts, the real wage is 'pro-cyclical' suggesting that the real wage moves directly (shares a positive relationship) with the state of the economy (GDP) growth. Another element of the business cycle fact(s) of economic time series is its timing: i.e., whether the economic variable is leading, coincident, or lagging (click Here for help with these terms and/or read pages 284-285 in text). According to your results above, how would you characterize the behavior of the real wage during this business cycle in terms of: I) it's cyclicality and 2) it's timing. Please consider all three of the possible timings (since we are are not sure) and then determine its cyclicality, based on the timing. There are three cases to consider.
e) 1he last four years of the Clinton Administration were arguably the absolute best in ~rw 'i ~ ~1-u-1)terms of the recent performance of the US economy (1/97-12/00). When we get to +w ~ec.re..e.J(.Chapter 3, we will discuss this period in much more detail and we refer to this period as tAft-v ~the "new economy." Of course one metric ofthe health of any economy is the behavior eof the real wage. In this part, we repeat the analysis above but use the final four years of \1\c....l'f\-lw'v\lW the Clinton Administration. In particular, calculate the real wage (W/P) the first month of ~ ~ ,~ jClinton's second term (1197) and compare it to the last month of Clinton's second rc.t~~r~·~ .o..term( 12/00). Did real wages rise or fall during this period? Please show 1 work.
f) In Florida, I used to fish on a party boat and tip the captain and mate every time I went fishing. Given that this was back in June of2003 and that the tip was $20, how much would the tip have to be now to equal the same purchasing power that $20 had back in June of2003? Use the CPI (the same price index that you have been using thus far) for your calculations. Please show all work.
g) Calculate the real wage when you were born and compare it to the real wage as of the present (make sure you write down the month and year you were born so we can verify your answer). Which real wage is higher and why? To answer, compare the percent change in W to the percent change in P over this time horizon.
To answer h) you need to use the followingv-»c5e \-\"'' ,·"'~ecreJ.Employment (N) Click Hereh) 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 (when you were born) as point A and the conditions as of the present as point B. Use actual numbers and label your points accordingly. You 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. (60 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 (rre) 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 wasn't 3% but 4% instead (your expectation rate of inflation was wrong). That is, actual inflation (rr) equaled 4% and thus your actual real rate, referred to as the ex-post real rate of interest isonly 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 i-TTe where the ex-post real rate is equal to i-TT. 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) Click HerePrice index CPI (P) Click HereExpected Inflation Click HereA 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% = TTe.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 the price 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% = TTiii) 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 getyour 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 rate 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 June 2008 and June 2009 (note that June 2009 is the last month ofthe Great recession-the official recovery, the one we are in now, began in July of 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 o"fthf future. Suppose we have two people who are trying to decide whether to consume today (June 2008) or save for the future and consume one year later, in June 2009. One person, let's call him Joe, is basing their decision on the ex-ante real rate of interest like most ofus 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 onthe 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* would be more likely to spend? Explain in detail and feel free to use the shopping c example we used in class.
c) From a macroeconomic perspective, why is deflation so bad? Please refer to consumer behavior and the corresponding behavior of firms in a deflationary environment.
d) 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 app_lies. Why ~s thi~ environme~fsu~hj nightmare for. the central bank and monetary pohcy? Explam usmg the--equat~ the real rate of mterest.
e) Suppose Joe, from part b) above, changes his expectation of inflation to equal the actual rate of inflation that occurred between June 2008 and June 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!
f) Given a deflationary environment, what can the central bank do to rid themselves of the nightmare? Explain. Click Here and Here for a hint! Explain why this move should work in terms getting rid of the nightmare.
3. (50 points total-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 GOPGOP Deflator ( P)GOPGDPCTPIa) Let us go back to the 1981 - 1982 recession-Click here for the NBER site. Note that officially, this recession began in third quarter of 1981 and ended in the fourth quarter of 1982. Calculate the percent change in nominal GDP during this recession (for all calculations use the data from 1981-07-01 to 1982-10-01 (GDP data is quarterly).
b) Now calculate the percent change in the GOP price deflator during this recession.
c) Now calculate the percent change in real GDP using the formula:%~RGDP = %~ (NGDP/P) = %~NGDP-%~Pwhere RGDP = real GDP: NGDP= nominal GDP: P =the GDP deflator
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 (note, you need to calculate real GDP using NGDP/P for two different time periods). 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.