1. This question relates to the distinction between a nominal and real interest rate, with one small twist added. An attempt is made to include a component of the opportunity cost of funds. The logic is that a nominal interest rate equals the sum of two items:
• An expected inflation: At any point in time we forecast ahead to get an expected inflation notion, yes the financial market are quite adept at this. Our solution to the forecasting problem is to use the one year just ended inflation rate as our estimate going forward.
• A real rate of interest: The real rate of interest represents a measure of what I earn, in excess of simple gains in purchasing power.
• If for example I made a loan to my son one year ago at an interest rate of 2%; then looking back if the inflation rate last year was 1.5%, then my real rate of return was 0.5%. If on the other hand, the inflation rate last year was 2.5%, then my real rate of return was -0.5%
For this question we are going to look at actual interest rates and calculate an inflation rate helping us to determine and then draw inferences about the real interest rate. All data needed is available in the Midterm.xlsx EXCEL workbook under the tab rates 1. If you wish you can obtain data from FRED below:
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FRED Graph Observations |
FRED Graph Observations |
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Federal Reserve Economic Data |
Federal Reserve Economic Data |
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Economic Research Division |
Economic Research Division |
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Federal Reserve Bank of St. Louis |
Federal Reserve Bank of St. Louis |
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DGS1 |
1-Year Treasury Constant Maturity Rate, Percent, Quarterly, Not Seasonally Adjusted |
CPIAUCNS |
Consumer Price Index for All Urban Consumers: All Items, Index 1982-1984=100, Quarterly, Not Seasonally Adjusted |
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Frequency: Quarterly |
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observation_date |
CPIAUCNS |
Inflation Rate |
Real Rate |
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2012-04-01 |
229.793 |
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2012-07-01 |
230.297 |
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Frequency: Quarterly |
2012-10-01 |
230.380 |
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observation_date |
DGS1 |
2013-01-01 |
231.740 |
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2013-04-01 |
0.13 |
2013-04-01 |
232.993 |
0.011709534 |
0.091 |
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2013-07-01 |
0.12 |
2013-07-01 |
233.874 |
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2013-10-01 |
0.13 |
2013-10-01 |
233.221 |
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2014-01-01 |
0.12 |
2014-01-01 |
234.997 |
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2014-04-01 |
0.10 |
2014-04-01 |
237.772 |
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2014-07-01 |
0.11 |
2014-07-01 |
238.044 |
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2014-10-01 |
0.15 |
2014-10-01 |
236.132 |
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2015-01-01 |
0.23 |
2015-01-01 |
234.849 |
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2015-04-01 |
0.25 |
2015-04-01 |
237.681 |
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2015-07-01 |
0.35 |
2015-07-01 |
238.305 |
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2015-10-01 |
0.47 |
2015-10-01 |
237.233 |
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2016-01-01 |
0.58 |
2016-01-01 |
237.386 |
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2016-04-01 |
0.57 |
2016-04-01 |
240.169 |
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2016-07-01 |
0.56 |
2016-07-01 |
240.968 |
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2016-10-01 |
0.76 |
2016-10-01 |
241.505 |
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2017-01-01 |
0.89 |
2017-01-01 |
243.414 |
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2017-04-01 |
1.13 |
2017-04-01 |
244.737 |
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2017-07-01 |
1.24 |
2017-07-01 |
245.708 |
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2017-10-01 |
1.55 |
2017-10-01 |
246.619 |
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2018-01-01 |
1.94 |
2018-01-01 |
248.804 |
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Our interest rate is the 1-Year Treasury Constant Maturity Rate. It is provided quarterly from April 2013 to January 2018. Its January 2018 value is 1.94. Note this is a quarterly average of daily transactions data.
The Consumer Price Index is also provided from April 2012 to January 2018, this is a quarterly average of monthly data. You can use the Consumer Price Index to calculate an inflation rate. Specifically, I want you to calculate the inflation rate over a year for each quarter. The yearly inflation rate for April 2013 is going to be determined by the April 2013 Consumer Price Index (232.993) and the July 2012 Consumer Price Index (230.297). Do not convert the calculation to percentages. So, the first inflation rate you calculate should be equal to 0.001709534. You are using, in a sense, a 1 year looking back inflation measure.
A. Calculate the inflation rate and the Real Rate of Interest for each quarter. The real rate equals the nominal rate minus the inflation rate.
B. Explain, in layman’s terms what a positive real rate of interest means for the economy and what a negative real rate of interest means for the economy. (Please avoid Investopedia and other sources use your own words).
C. According to our calculations what quarters, if any, have negative real rates of return. Do you have any expectation as to why this occurred?
2. Suppose that President Trump were to make the claim that “Our unemployment rate is falling from its level of 2 years ago, this is a strong positive sign of our economic health and vitality.” A Bureau of Labor Statistics report is released, confirming President Trump’s statement; however, the BLS report reveals that in addition to a falling unemployment rate, the labor force has declined as well.
A. You are tasked with job of producing a counter argument to President Trump’s claim of economic “health and vitality” and must do so at a level of Economics used in this course. What is your counter argument? Can you produce a numerical example that would cast doubt on President Trump’s claims?
B. You are tasked with the job of further supporting President Trump’s claim of economic “health and vitality” and must do so at a level of Economics used in this course. What is your counter argument to the claim made in part A. above?
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