2. We have the following data on interest rates and the price level (in the Unit
ID: 1093137 • Letter: 2
Question
2. We have the following data on interest rates and the price level (in the United States) for the years 1977-2002:
Year
Price Level
Interest Rates (Percent)
1977
60.6
5.6
1978
65.2
7.6
1979
72.6
10
1980
82.4
11.4
1981
90.9
13.8
1982
96.5
11.1
1983
99.6
8.8
1984
103.9
9.8
1985
107.6
7.7
1986
109.6
6.1
1987
113.6
6.1
1988
118.3
7
1989
124
8
1990
130.7
7.5
1991
136.2
5.5
1992
140.3
3.6
1993
144.5
3.1
1994
148.2
4.7
1995
152.4
5.6
1996
156.9
5.1
1997
160.5
5.2
1998
163
4.9
1999
166.6
4.8
2000
172.2
5.9
2001
177.1
3.4
2002
179.9
1.7
(a) Calculate the rate of inflation for the years 1978-2002
(b) Calculate the expected rate of inflation for the years 1979-2002 assuming (i) people expect the rate of inflation to be the average rate of inflation in the two previous years and (ii) people have perfect foresight and expected inflation just equals actual inflation.
(c) For each of the assumptions in part b, calculate the real interest rate for the years 1977-2002.
(d) In light of this example, explain why economists have such a difficult time measuring the real interest rate.
(e) How do you think people forecast inflation? What information do they use? Do you think they systematically underestimate changes in the price level?
Year
Price Level
Interest Rates (Percent)
1977
60.6
5.6
1978
65.2
7.6
1979
72.6
10
1980
82.4
11.4
1981
90.9
13.8
1982
96.5
11.1
1983
99.6
8.8
1984
103.9
9.8
1985
107.6
7.7
1986
109.6
6.1
1987
113.6
6.1
1988
118.3
7
1989
124
8
1990
130.7
7.5
1991
136.2
5.5
1992
140.3
3.6
1993
144.5
3.1
1994
148.2
4.7
1995
152.4
5.6
1996
156.9
5.1
1997
160.5
5.2
1998
163
4.9
1999
166.6
4.8
2000
172.2
5.9
2001
177.1
3.4
2002
179.9
1.7
Explanation / Answer
Please see the table with results below and then the explanations at the bottom.
(a) Calculate the rate of inflation for the years 1978-2002
Done in table above. To get the inflation rate we used this formula: [(Current years price - Previous years price ) / Previous years price] x 100
(b) Calculate the expected rate of inflation for the years 1979-2002 assuming (i) people expect the rate of inflation to be the average rate of inflation in the two previous years and (ii) people have perfect foresight and expected inflation just equals actual inflation.
Both of these are done in table above. For (i) just add the previous year inflate and current years inflation and then divide by 2. For (ii) it just equals the actual inflation rate.
(c) For each of the assumptions in part b, calculate the real interest rate for the years 1977-2002.
Done in table above. Real interet rates = Interest rate - inflation.
(d) In light of this example, explain why economists have such a difficult time measuring the real interest rate.
Clearly, because there are so many different ways to measure inflation. The real interest rates will depend on how we measure the inflation.
(e) How do you think people forecast inflation? What information do they use? Do you think they systematically underestimate changes in the price level?
They look at their pay increases and compare it to how much it cost them to live. Yes, I think they do underestimate inflation. Especially the government indexes that exclude food, energy, etc.
Year Price Level Interest Rates (Percent) Rate of Inflation Expected Rate of Inflation (1st Method) Expected Rate of Inflation (2nd Method) Real Interest Rate (Part I) Real Interest Rate (Part 2) 1977 60.6 5.60 1978 65.2 7.60 7.59% 1979 72.6 10.00 11.35% 9.47% 11.35% 0.53% -1.35% 1980 82.4 11.40 13.50% 12.42% 13.50% -1.02% -2.10% 1981 90.9 13.80 10.32% 11.91% 10.32% 1.89% 3.48% 1982 96.5 11.10 6.16% 8.24% 6.16% 2.86% 4.94% 1983 99.6 8.80 3.21% 4.69% 3.21% 4.11% 5.59% 1984 103.9 9.80 4.32% 3.76% 4.32% 6.04% 5.48% 1985 107.6 7.70 3.56% 3.94% 3.56% 3.76% 4.14% 1986 109.6 6.10 1.86% 2.71% 1.86% 3.39% 4.24% 1987 113.6 6.10 3.65% 2.75% 3.65% 3.35% 2.45% 1988 118.3 7.00 4.14% 3.89% 4.14% 3.11% 2.86% 1989 124 8.00 4.82% 4.48% 4.82% 3.52% 3.18% 1990 130.7 7.50 5.40% 5.11% 5.40% 2.39% 2.10% 1991 136.2 5.50 4.21% 4.81% 4.21% 0.69% 1.29% 1992 140.3 3.60 3.01% 3.61% 3.01% -0.01% 0.59% 1993 144.5 3.10 2.99% 3.00% 2.99% 0.10% 0.11% 1994 148.2 4.70 2.56% 2.78% 2.56% 1.92% 2.14% 1995 152.4 5.60 2.83% 2.70% 2.83% 2.90% 2.77% 1996 156.9 5.10 2.95% 2.89% 2.95% 2.21% 2.15% 1997 160.5 5.20 2.29% 2.62% 2.29% 2.58% 2.91% 1998 163 4.90 1.56% 1.93% 1.56% 2.97% 3.34% 1999 166.6 4.80 2.21% 1.88% 2.21% 2.92% 2.59% 2000 172.2 5.90 3.36% 2.78% 3.36% 3.12% 2.54% 2001 177.1 3.40 2.85% 3.10% 2.85% 0.30% 0.55% 2002 179.9 1.70 1.58% 2.21% 1.58% -0.51% 0.12%Related Questions
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