Understanding Real Interest Rates and the Federal Reserves Crisis Response

Abstract

Question 2 Use the data in the tab Question02 of the file ASSGN02.xlsx. The data item 1 Year Inflation is calculated as the yearly change in the CPI expressed not in a percent format but as a whole number, i.e. the result is multiplied by 100. The value for 1987 is 1.365 Verify this number showing me the calculation that created it. I.e. write it out in a calculable form. When rounded to 3 decimal places it is 1.365 Using the 1 year government bond rate, for each month in the file calculate the ex-post real inflation rate call this newly created variable 1YearRealRate. The value for 1986.01 is 3.76. Here report the average of 1YearRealRate _0.67________. For each year in the table below show me the average values for 1 Year Inflation, DGS1, and 1YearRealRate. Table 1: Values Based on Monthly Averages We learned in the “macro part” of the course that one weapon that the Federal Reserve has in terms of impacting the economy is to lower interest rates. Identifying the “periods of crisis” in 2008-2010 and the years 2020 – 2022 do you see evidence of this effort? Fully explain. Analyzing at table 1, it is true that the Federal Reserve reduces the interest rates during a crisis. For instance, the average DGS1 for 2008 is 1.823 while the DGS1 for 2009 is 0.473. These rates were reduced when America experienced a great financial recession. Additionally, the DGS1 for 2020 is 0.378, while the 0.378 for 2021 is 0.104, which was during the Covid 19 crisis. These values are low when compared to the other DGS1 values. Considering the values of the 1-year real rate for the last 3 years in the table is it likely or not that people in the US are going to work more years and/or retire later than they would if the real interest rate was positive? Fully explain and justify. The 1-year real rate for the last three years in the table above is negative. This implies that the inflation rate is higher than the nominal interest rate. High inflation rates mean that the prices of the commodities increase hence one is left with very little money to save. People in the US will have to work for more years before they retire to try and save a little more. If the 1-year real rate was positive, it would mean that the inflation rate is less than the nominal interest rate. High inflation rates devalue people’s income and savings. The US people will have to work more so as to gather more assets that will last them more when they retire. Question 5 In the aggregate supply and demand model material, there is a concept known as the GDP gap. The gap is defined as the difference between actual and potential GDP. Use the data in the tab Question 05 to do the following. Note that the data appear in time reverse order, i.e. the newest ones are on top of the spreadsheet. For each quarter calculate the GDPGap% as (Actual-Potential)/Actual. The average of GDPGap% over all the available data is __0.77%___________. For the quarter 2022.1 the gap is calculated for you. The largest negative gap was in 2020.2. Consider the economy moving from 2020.1 to 2020.2. Name at least 2 things that impacted aggregate demand moving from 2020.1 to 2020.2. Provide, in your word file a picture of an aggregate supply and demand model that shows the nature of these changes on aggregate demand. Narrate the picture appropriately with your changes. If you borrow this picture you must indicate where it is from. The largest negative gap was recorded in 2020.2 at -12.41%. When the Covid-19 pandemic struck, the US economy was unable to create enough job opportunities for all the people who were willing to work. When the Covid pandemic started, many companies closed down to curb the spread of the virus. Therefore, the actual output of the US was less in 2020.2, than the output it would have produced if it operated at a full capacity. A decrease in income meant a decrease in the overall spending and consumption of the country. Figure 1 Figure 1 above shows a scenario where there is a negative GDPGap where the aggregate demand is not enough for an economy to operate at full capacity. Figure one supports the interpretation that the total output, employment level, and price level face downward pressure. Additionally, an increase in the aggregate demand leads to an increase in the real GDP and the overall price while a decrease in the aggregate demand means a decrease in the real GDP and a decrease in the price of the commodities. The largest negative gap was in 2020.2. Consider the economy moving from 2020.1 to 2020.2. Name at least 1 thing that impacted aggregate supply (short run) moving from 2020.1 to 2020.2. Provide, in your word file a picture of an aggregate supply and demand model that shows the nature of these changes on aggregate demand. Narrate the picture appropriately with your changes. The largest negative gap was recorded in 2020.2 at -12.41%. A shift in the aggregate supply in the short run is mostly caused by stickiness in the wages and the prices of the commodities, The changes in the income earned and the purchasing power impact the real and the potential GDP. Additionally, price and wage stickiness also lead to an economy failing to produce full employment output. Expectations of an increase in prices and productivity rates are other causes of the shift in the aggregate supply in the short run. Figure 2 Source: https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/national-income-and-price-determinations/short-run-aggregate-supply-ap/a/lesson-summary-short-run-aggregate-supply#:~:text=Aggregate%20supply%20slopes%20up%20in,unemployment%20in%20the%20short%20run Figure 2 shows that price stickiness causes the short-run aggregate supply curve to slope upward. Therefore, a high price level implies more output while a low price means less output in the economy and low potential and actual real GDP. What is the average rate of growth in Potential GDP over the quarters of 2020 based on the official data for the most recent 8 quarters of data. Over the year of 2020, did the level of potential output increase or decrease in your opinion. Fully explain and if you are observant you will see that maybe the official measure is telling us one thing and, well, other things are happening in the model or in the world. No penalty here for taking a stand. However, if you say potential GDP is measured/estimated correctly – OR – if you say potential GDP is not measured/estimated correctly you need to tell me why. That is you need to determine the “causes or determinants” of potential GDP and go from there. The average growth in Potential GDP for the year 2021 is 19778.648 while the Potential GDP for the 4 quarters of 2020 is 19437.619. This implies that the level of potential output decreased in the year 2020. This is when we look at the...