ECON 304 HW 2

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Name _____________________ Date_________ last 4 PSU ID _______ Economics 304WD -- Homework Lesson 2 - Real vs Nominal Economic Variables 90 points  You need to show your work, not just the final answer  Use the template to complete your work or points will be taken off.  Please put your name and PSU ID number at the top of the page  Save the file on your computer ( .PDF is the only format allowed ) and then upload it to the Canvas dropbox for this homework assignment.  Be sure your assignment is all on one file. Failure to submit a single file will result in points being deducted In this 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’ will be chapter 3 and it is all about the factors of production, 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 %ΔW vs. the %ΔP, see this graph from the FRED site . 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. (See the National Bureau of Economic Research (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 percent change 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. 1. (15 points total) Use the following two links to answer the following questions: 1 FRED stands for F ederal R eserve E conomic D ata.- see the FRED website .

Nominal Wages (W) Price index CPI (P) 2 Let us go back to the 1981 – 1982 recession – review the NBER site . Note that officially, this recession began in third quarter of 1981 and ended in the fourth quarter of 1982. a) (5 points) Calculate the real wage (W/P) the first month of the recession 7/81 and compare it to the last month of the recession 11/82. What is the percent change in the real wage during this most recent recession? Please show all work and round to two decimal places. W/P (7/81) = W/P (11/82) = %Δ(W/P) = b) (5 points) Now calculate the real wage during the first month of the recovery, 12/82 and compare it to the real wage right before the following recession, 6/90. 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. 2 8.142857 8.15300546 -0.13331575% July 1981 Nominal Wages 7.46 July 1981 Price Index 91.5 November 1982 Price Index 98 November 1982 Nominal Wages 7.98 7.46 7.98 = 8.15300546 ∆ Nominalwages = ( 7.98 − 7.46 ) 7.46 × 100 = 6.97050938% ∆ Price index = ( 98 − 91.5 ) 91.5 × 100 = 7.10382513% 7.98 .98 = 8.142857 Nominalwages∆ − Price Index ∆ =− 0.13331575

What is the percent change in the real wage during this time period? Please show all work and round to two decimals. W/P (12/82) = W/P (6/90) = %Δ(W/P) = c) (5 points) What is the main reason why economists would like to use the real wage when looking at changes over time? 3 7.85219399 8.20880245 -5.77598992% June 1990 Nominal Wages 10.20 June 1990 Price Index 129.9 December 1982 Nominal Wages 8.02 December 1982 Price Index 97.7 8.02 97.7 = 8.02 .977 = 8.20880245 10.20 129.9 = 10.20 1.299 = 7.85219399 ∆ Price = ( 129.9 − 97.7 ) 97.7 × 100 = 32.9580348% ∆Wage = ( 10.20 − 8.02 ) 8.02 × 100 = 27.18204488% ∆ % = 27.18204488% − 32.9580348% =− 5.77598992% Economist today uses real wages when considering at deviations. To explain this in simple details real wages are changed for inflation, and this is how we define living standard changes. As an economist purchasing power is evaluated my examining real wages too.

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2. question. One is a Ted Talk and the other is an NPR news story. You can also access them via the links below: https://www.ted.com/talks/michael_green_what_the_social_progress_index_can_reve al_about_your_country http://www.npr.org/templates/story/story.php?storyId=127586501 Why do economists use GDP to measure the wellbeing of society? Is this the best way to do so? Refer to the items above in discussing other ways to measure the overall wellbeing of a society. 3. (20 points) 4 Economist Simon Kuznets and the report he delivered was national income 1929-32. This report later became the foundation on how we judge the success of a country. Significantly we consider gross domestic product as a display of a society’s standard of living. A fact to mention; GDP does not directly account for leisure, environmental quality such as air quality, ranks of health, and educational human capital development. Introducing the Social Progress Index to the economic system, it’s a measure of the well-being of society, this is not gross domestic product. The social progress index is founded on three proportions. First proportion of the pie is “Does everyone have the basic needs for survival in humanity? This consists of food, water, shelter and safety. Second proportion of the pie is “Does everyone have access to the building blocks to improve their lives as a human capital?” This consists of information, educational and training, importantly the human capital’s heath and a sustainable environment. Third proportion to sum up the whole economic pie. “Does every human capital have access to pursue their goals and dreams?” This can consist of liberty of choice, liberty from discrimination and access to the common world information. From the informal philosophy, one should not try to change something that is working well. The economic system works well to our society leading to the US as the greatest economy in the nation.

You will need to use the following links to answer this question. Nominal one year rates ( i ) Click Here Price index CPI (P) Click Here Expected Inflation Click Here In this part of question 2, we are going to compare the most recent one year real interest rates in the US - both ex-ante and ex-post. 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% = π 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 = %Δ P. Using the CPI data, we have the price index equaling 217.7 in 7/2010 (beginning of August given the end of month data) and 225.6 in 7/2011 (end of July, 2011). Note, this is a 12 month period. The actual rate of inflation during this time is 3.63% = π 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. 5

a) (5 points) Using the most recent data , calculate the ex-ante and ex-post real interest rates. Show your work. Ex-ante r = Ex-post r = b) (5 points) From a macroeconomic perspective, why is deflation so bad? Please refer to consumer behavior and the corresponding behavior of firms in a deflationary environment. 6 -3.51 -6.41 1.89% − 5.4% =− 3.51% ex − ante realrateof interest 1.89 − 8.3 =− 6.41 ex − post real Deflation is not good from a macroeconomic perspective. Deflation is defined as a decline in the in the general price level. This means deflation is a negative rate of inflation. The relationship between deflation and the economy is it lowers the economic growth. In other terms, deflation increases the real value of debt, and this reduces the spending power of firms and consumers. A real scenario can occur when consumers decide to not buy goods or service from your brand. Firms may fall into the decline of production cuts and worst-case letting employees go.

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c) (10 points) Discuss the fact that persistent deflation is the central bank's worst nightmare. 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 and refer to both the ex-post and ex-ante real rate of interest. \ 7 To the central bank, persistent deflation is terrible. It is terrible because it is difficult to stop. Banks will have to adapt the nominal interest rate if deflation proceeds to be insistent. The fisher equation is the difference between the nominal interest rate and expected inflation rate, this equals the real interest rate.

4. (25 points) Hy Marks buys a one-year government bond on January 1, 2011, for $500. He receives principle plus interest totaling $515 on January 1, 2012. Suppose that the CPI is 200 on January 1, 2011, and 206 on January 1, 2012. This increase in prices is different than Hy had anticipated; his guess was that the CPI would be at 201 by the beginning of 2012. a. (5 points) Calculate the nominal interest rate and round your answer in percentage points to one decimal place. Nominal Interest Rate = 8 3% ( 515 − 500 ) 500 × 100 = 3

b. (5 points) Calculate the actual inflation rate and round your answer in percentage points to one decimal place. Actual Inflation Rate = 9 3% ( 206 − 200 ) 200 × 100 = 3

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c. (5 points) Calculate the real interest rate and round your answer in percentage points to one decimal place. Real Interest Rate = d. (5 points) Calculate Hy’s expected inflation rate and round your answer in percentage points to one decimal place. Expected Inflation Rate = 10 0% R= 3-3 = 0 .5% ( 201 − 200 ) 200 × 100 = .5

e. (5 points) Calculate Hy’s expected real interest rate and round your answer in percentage points to one decimal place. Expected Real Interest Rate = 11 2.5% R= -.5 + 3 = 2.5

5. (20 points) 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 Deflator (P) Let us go back to the Great Recession– review the NBER site . Note that officially, this recession began in fourth quarter of 2007 and ended in the second quarter of 2009. a) (5 points) Calculate the percent change in nominal GDP during this recession (for all calculations use the data from 2008-01-01 to 2009-07-01 (GDP data is quarterly). Please show all work and round to two decimal places. %∆NGDP = 12 -1.57480981% January 1, 2008 Nominal GDP = 14651.039 July 1, 2009 Nominal GDP = 14420.313 ( 14420.313 − 14651.039 ) 14651.039 × 100 =− 1.57480981

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b) (5 points) Now calculate the percent change in the GDP price deflator during this recession. %∆Deflator = 13 1.43530442% July 01, 2009 GDP Deflator = 94.912 January 01, 2008 GDP Deflator = 93.569 ( 94.912 − 93.569 ) 93.569 × 100 = ¿ 1.43530442 %

c) (5 points) Now calculate the percent change in real GDP using the formula: %ΔRGDP = %Δ (NGDP/P) = %ΔNGDP - %ΔP where RGDP = real GDP: NGDP= nominal GDP: P = the GDP deflator %∆RGDP = d) (5 points) Was the economy experiencing stagflation during this time? Include the definition of stagflation in your answer. 14 -3.01% -1.57%-1.44% Yes, Stagflation happens when high inflation and slow economic growth happen at the same time.

ECON 304 HW 2

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