Finance 462
Solutions to Problem Set #2
1) Note that the inflation rate is defined as:
((Current Price Level - Previous Price Level)/Previous Price Level)*100 = Inflation rate
To annualize, multiply the GDP deflator inflation rate by 4 (its quarterly), multiply the CPI inflation rate by 12 (its monthly).
Average CPI inflation = 7.6%
Average GDP Def. Inflation = 6.8%
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The CPI reports a higher inflation rate. The main reason is that it is assuming that consumption patterns are constant when, in fact they are not.
2) Consider the following data: Assume that capital's contribution to output is equal to 1/3 while labors contribution is equal to 2/3.
Year |
Real GDP (Y) |
Total Capital
Stock (K) |
Total Labor
Hours (L) |
2000 |
$8.162T |
$13.034T |
254,044 |
2001 |
$8.183T |
$13.571T |
253,752 |
Real GDP Growth = ((8.183 - 8.162)/8.162)*100 = .25%
Capital Growth = ((13.571 - 13.034)/13.034)*100 = 4.1%
Employment Growth = ((253,752 - 254,044)/254,044)*100 = -.15%
Labor Productivity Growth = GDP Growth - Labor Growth = .25% - (-.15%) = .40%
MFP Growth = GDP Growth - (1/3)(4.1) - (2/3)(-.15) = -1.01%
3) Unemployment = (Unemployed/Labor Force)*100
If an individual chooses to leave the labor force, then they are are not counted as unemployed
4) Consider the following two assets:
· A 90 day TBill with a face value of $100 and a current market price of $98.50
· A 10 year STRIP (a bond that makes one payment in 10 years) with a face value of $100 and a current market price of $63.75.
90 Day TBill
(($100 - $98.50)/$98.50)*100 = 1.5% * 4 = 6% Annual Return
10 Year STRIP
(($100 - $63.75)/$63.75)*100 = 57%/10 = 5.7% Annual Return
The TBill pays a higher rate of return (the yield curve is downward sloping)
5) Suppose that the current interest rate is 5.75% (annualized). The CPI increased by .3% over the previous month and the public is expecting that trend to continue. What is the (expected) real rate of return?
The monthly CPI inflation rate is .3%. Therefore, the annualized rate is .3*12 = 3.6%.
The Real Return = Nominal Return - Expected Inflation = 5.75 - 3.6 = 2.15%