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Homework 3 Economics 503 Foundations of Economic Analysis Practice 1. Real Interest Rate Below is a table showing a nominal interest rate on bonds that was prevailing in the December of each year from 1991-2005. Also shown is the level, P, of the CPI index for 1991-2006. Assume that there is a fixed equilibrium real interest rate in each period of 2.5% (r = .025). Use that estimate to derive the forecast of inflation for the subsequent year. Use this to calculate, the actual inflation rate in Hong Kong in the years 1992-2006. Calculate the ex post real interest rate for HK for each year the period 1991-2005? In which years, was the ex post interest rate greater than the ex ante real interest rate? In which years was the ex post real interest rate negative? P Dec, 1991 Dec, 1992 Dec, 1993 Dec, 1994 Dec, 1995 Dec, 1996 Dec, 1997 Dec, 1998 Dec, 1999 Dec, 2000 Dec, 2001 Dec, 2002 Dec, 2003 Dec, 2004 Dec, 2005 Dec, 2006 i 73.1 79.9 86.8 94.6 100.8 107.6 112.7 111.1 108 105.9 99.4 100.3 99.1 99.7 101 102.9 5.18 5.47 4.26 7.74 5.54 5.58 9.6 5.96 6.37 5.42 3.41 1.763 1.125 0.993 3.983 3.519 2. Real Exchange Rate. Construct a real exchange rate for HK for the years 20022007. In 2002, the relative price of a market basket of goods in HK in HK$ relative to the price of goods in the US in US$ is HK$6.9 per 1 US$ while the exchange rate is 7.8. Below is the CPI for HK and the US with base years of 2000. Price: P HK 2002 2003 2004 2005 2006 2007 100.3 99.1 99.7 101 102.9 103.2 US 180.9 184.3 190.3 196.8 201.8 207.92 In which years is the HK undervalued and which is it overvalued? 3. Money Market Assume there is a negative supply shock in the United States which reduces real and nominal GDP. The central bank wants to conduct monetary policy to stabilize the price level. Draw a picture of the money market. Show how the money supply and demand curve would shift in response to these events. What would happen to the money market interest rate and money supply? 4. Real Exchange Rate Growth The following chart shows the CPI in the USA and Hong Kong for the years 2003-2008. Assume that the growth in Hong Kong’s exchange rate is zero. Calculate the growth rate of the real exchange rate for 2004-2008. What is the average growth rate of Hong Kong’s real exchange rate for those years? CPI USA 2003 2004 2005 2006 2007 2008 181.7 185.2 190.7 198.3 202.4 211.1 HK 101.3 99.8 99.5 101.3 103.3 106.7 5. Loanable Funds Market Some economists argue that the savings behavior is not very responsive to the interest rate. Other economists argue that savings is strongly affected by the interest rate. Use the loanable funds framework for a large, closed economy. Compare the effect of expansionary fiscal policy (i.e. an increase in government deficits) on the interest rate and investment in A) an economy in which the supply of loanable funds (S) was inelastic with respect to the interest rate; with the effect in B) an economy in which the supply of loanable funds is very elastic. Draw a graph of each theory to show under which theory there is a bigger impact on investment and under which theory there is a bigger impact on the interest rate. 6. Foreign Exchange Market. Diamonds are discovered in Australia. Foreigners want to buy these diamonds and need Australian dollars to do so. Assume that this discovery has no particular effect on Australian demand for foreign goods or assets. Draw two graphs of the Forex market: 1) Demonstrate the effect on the Australian dollar exchange rate if Australian monetary policy remains unchanged so the exchange rate is allowed to fluctuate; 2) Demonstrate the effect on the market if the Reserve Bank of Australia conducts monetary policy to keep the exchange rate from changing. 1. he Organization of Economic Co-operation and Development (OECD) constructs theoretical measures of potential output for most of the G20 countries and some others which are used to develop projections in their semi-annually published Economic Outlook publication. Gather information from the OECD Stats Extract website on the output gap and unemployment rates in 2008 and 2009 from the following website http://stats.oecd.org/index.aspx . On the left hand bar of menus, open the menu marked OECD Economic Outlook and the sub-menu marked OECD Economic Outlook Current and Recent Editions. Click on the link on that menu marked Economic Outlook No 86 December 2009 - Annual Projections for OECD Countries (or go directly to this link http://stats.oecd.org/Index.aspx?DataSetCode=EO86_MAIN ). Under Current Data Selection, Click on the link marked Variable [0/142]. This should bring up a selection of menus. Open the menu called SUP:Supply Block and check GAP: Output gap of the total economy. Open the menu called LAB: Labour markets and check UNR: Unemployment rate. Choose under Time and Frequency years 2008 and 2009; Choose under Country, 10 countries including Australia, Canada, France, Germany, Italy, Japan , Netherlands, Spain, United Kingdom, and USA. Download the data on the output gap and unemployment rate by country for 2009. Fill in the following chart. Output Gap Unemployment Rate AUS: Australia CAN: Canada FRA: France DEU: Germany ITA: Italy JPN: Japan NLD: Netherlands ESP: Spain GBR: United Kingdom USA: United States Calculate the cross-country correlation between the output gap and the unemployment rate across countries. 2. sing aggregate demand, short-run aggregate supply and long-run aggregate supply curves, explain the process by which each of the following economic events will move the economy from one long-run macroeconomic equilibrium to another. Illustrate with diagrams. In each case, what are the short-run and long-run effects on the aggregate price level and aggregate output? a. There is a decrease in households’ wealth due to a decline in the stock market. b. There is an increase in the wealth of households in the economy of a foreign trading partner. 3. Consider again the case (a) from the above problem, when household wealth increases. Focus on how event (b) will change money market interest rates. Draw a graph of the money market and show what would happen to money market interest rates after event (1b) if the central bank left the money supply unchanged. (Hint: After event (1b), GDP will change. How will this change affect money demand?). 4. Obtain annual data on US real GDP, potential GDP, and the unemployment rate from the US Congressional Budget Office Website (US Congressional Budget Office Website ). Data on Real GDP with 2000 prices and the unemployment can be found in Excel format by following the link at: Details of CBO's Year-by-Year Forecast and Projections for Calendar Years 2009 to 2019 (Along with data for 1950 to 2006) DATA Data on potential GDP with 2000 prices can be obtained by following the ling at: Supplemental Information on Key Assumptions in CBO’s Projections of Potential Output DATA Calculate the output gap and the unemployment rate for the years 1950 to 2006. Calculate the correlation between the two using the Data Analysis tool in Excel. 5. In 2005, a hurricane hit New Orleans, Louisiana, an important transportation and oil refining center in the USA, one of Hong Kong’s key for the petrochemical industry in that country. a. Consider the impact of the recent hurricanes that devastated that city as a temporary supply shock for the USA. Discuss briefly, using one graph, the outcomes that we would have been likely to see in terms of goods markets in the USA as a result of this negative business cycle shock. b. Analysts are also worried that the natural disaster might have had a negative impact on consumer confidence. Discuss briefly, using one graph, the differences in outcomes that we would observe if this demand side effect were stronger from the outcomes that we would observe if the supply side effects were dominant. 6. Does the BOJ have a Taylor Rule? The following table shows numbers for Japan’s inflation rate, output gap, and the uncollateralized call money interest rate for the years 1990 to 2000. 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 i. Output Actual Gap Inflation Interest Rate 3.30% 3.02% 7.56% 4.09% 3.22% 7.48% 2.50% 1.70% 4.82% 0.51% 1.26% 3.18% -0.87% 0.69% 2.41% -1.20% -0.12% 1.15% 2.14% 0.13% 0.48% 2.32% 1.75% 0.52% -1.48% 0.67% 0.44% -2.46% -0.33% 0.06% -2.57% -0.71% 0.12% Calculate the inflation gap (i.e. the difference between inflation and target inflation) in each period if Japan had used a target inflation rate of 2% in each year. What is the average inflation gap during the period 1990-1995 (inclusive) and for 1996-2000? ii. Calculate the interest target, iTGT, for every period if the Bank of Japan had used a Taylor rule as specified in class. Compare this with the actual interest rate. Does the Bank of Japan adjust the target interest rate to domestic inflation and output? iii. Some have argued that the BOJ was not aggressive enough in cutting interest rates in the early 1990’s to get the economy out of the slump. What was the average interest rate during the period 1992-1997? What was the average interest rate suggested by a Fed-style Taylor rule. Which was larger? iv. What difficulties did the Bank of Japan have in implementing the Taylor rule in 1999 and 2000? 1. Construct an AS-AD model of the economy. Begin by assuming the economy is in a long-run level of equilibrium with the aggregate supply curve crossing the aggregate demand curve at the level of potential output. Use the model to describe how each of the events will change the macroeconomic equilibrium in the short-run. Suppose that policymakers allow the self correction mechanism to bring GDP back to the long-run equilibrium. Use the model to describe how each of the events will change the economy in the long-run. Illustrate with diagrams. a. An increase in personal taxes on households. b. An increase in the quantity of money. c. An increase in government purchases. 2. The Liquidity Crisis and the Taylor Rule in Hong Kong. You are given the following Table listing the output gap, the CPI and the overnight HIBOR Rate in Hong Kong. 2007Q4 2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 2009Q2 2009Q3 Output Gap CPI Inflation xxx 107.4 xxx 0.049219808 108.2 0.029795 0.0299929 110.1 0.013160519 107.7 -0.013435423 109.6 -0.063140353 109.5 -0.037229897 109.2 -0.040702363 108.2 Interest Rate Under Taylor Rule xxx Actual Interest Rate xxx 0.00781 0.00875 0.024375 0.00225 0.00375 0.0013 0.0013 a. For each quarter, construct the inflation rate on an annual basis. This is obtained just P Pt 1 by constructing the % growth rate of the price that occurs in a given quarter t Pt 1 and then multiplying the result by 4. An example is constructed in the Table for the 1st Quarter of 2008. b. Construct a hypothetical interest rate for HK with the Taylor rule using the CPI inflation. CPI data and an assumption of an inflation target of 2%. c. Compare the interest rate with that observed in HK. Note that the interest rate has been below 1% in every quarter except the 2008Q3. Has the interest rate been higher or lower in HK than that suggested by the Taylor rule?