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%

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%