ECO304 assignment 2

Name __________________________ _________ last 4 PSU ID _______

Chuderewicz

YOU MUST USE THIS AS A TEMPLATE – THAT IS – MAKE SPACE FOR YOUR ANSWERS BY HITTING ENTER (you certainly don’t need to type this assignment)– LEAVE THE QUESTIONS AS THEY ARE – AND PLEASE STAPLE! ALSO,

Due Thursday, 9/8 at the beginning of class – no late papers accepted!

Instructions: Please show all work or points will be taken off. Good luck!

1. (70 points total – 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 labor market and 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 Here.

I recall back in the early 1990s (back around the time when most 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 Administration.

Use the following two links to answer the following questions:

For Nominal Wages (W) Click Here

Price index CPI (P) [2] Click Here

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) Now calculate the percent change in nominal wages (W) from 1/89 to 12/92 and compare to the percent change in the general price level (P) over the same time period. Are your results consistent with your answer in part a)? Please refer to the following equation using the real world numbers.

%?(W/P) = %?W - %?P

c) 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.

d) Now calculate the percent change in nominal wages (W) from 1/97 to 12/00 and compare to the percent change in the general price level (P) over the same time period. Are your results consistent with your answer in part c)? Please refer to the following equation using the real world numbers.

%?(W/P) = %?W - %?P

e) In Florida, I used to tip the captain and mate every time I went fishing. Given that this was back in June of 2003 and that the tip was $20, how much would the tip have to be now (July 2011) to equal the same purchasing power as $20 had back in June of 2003? Use the same price index that you have been using thus far, Please show all work.

f) Calculate the real wage when you were born and compare it to the real wage as of July 2011 (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 g) you need to use the following link:

Employment (N) Click Here 

g) 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 July 2011 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?

2. (50 POINTS total - 10 points each part) Another 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 is in order. 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 wasn’t 3% but 4% instead (your expectation 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 your expectations of inflation are wrong. To summarize, the ex-ante real rate is equal to i – ?e where the ex-post real rate is equal to i – ?. In general, it is the ex-ante rate that is most important since we base decisions today, in part, on expectations of the future.

In this problem. we are going to calculate real interest rates, both ex-post and ex-ante. The data you need for this problem is given below:

Nominal one year rates (i)  Click Here 

Price index CPI (P)  Click Here

Expected Inflation Click Here

A couple notes are in order.

i) Expected inflation data is one year hence - so 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 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% = ?

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 plus whatever the nominal interest rate is). In viewing the data, the one year rate in July 2010 is 0.29%. So obviously, 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.

We go back to the one year time period from July 2008 to July 2009, basically the final 12 months of the Great Recession (the recession actually ended in June of 2009, click Here for the NBER site - look at right hand side of page).

2 a) Calculate the ex-ante and ex-post real rate of interest between July 2008 and July 2009. Why are they 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 (July 2008) or save for the future and consume then (July 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.

We discussed the evils of deflation.

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 applies. Why is this environment such a nightmare for the central bank and monetary policy? Explain.

e) 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 GDP GDP

GDP Deflator (P) GDPCTPI

a) Let us go back to the 1973 – 1975 recession – Click here for the NBER site. Note that officially, this recession began in fourth quarter of 1973 and ended in the first quarter of 1975. Calculate the percent change in nominal GDP during this recession (for all calculations use the data from 1974-01-01 to 1975-04-01 (GDP data is quarterly).

b) Now calculate the percent change in the GDP price deflator during this recession.

c) Now calculate the percent change in real GDP using the formula:

%?RGDP = %? (NGDP/P) = %?NGDP - %?P

where 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 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.

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[1] FRED stands for Federal Reserve Economic Data.- click Here 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.