Econ 2

If the nominal interest rate were 5% and the expected inflation rate were 2%, what would the real interest rate be?

3%

Mary is unemployed because she lost her job at McDonald's after the state increased the minimum wage.

Structurally Unemployed

Phil is currently unemployed because the tire factory where he used to work installed robots, which replaced 500 laborers, including Phil.

Structurally Unemployed

Assume that the residents of a nation become more patient (experience a reduction in their time preferences).a. What will happen to the interest rate in that nation? What will happen to the equilibrium level of investment in that nation? Explain your answers.

Supply of loanable funds shifts to the RIGHT/INCREASE which will decrease the interest rate and increase the level of investment in the nation (otherwise known as the equilibrium quantity of loanable funds). Draw this graph as part of your explanation.

Suppose that you also take out a $1,000 loan at the Cavalier Credit Union. The loan agreement stipulates that you must pay it back with 4% interest in one year, and again, the inflation rate is expected to be 2%. -If the inflation rate turns out to be 3% rather than 2%, who will be hurt by this? Why?

The bank is hurt by this. They thought they were going to earning 2% real interest on the loan they gave you but it turns out that they will only earn 1% real interest on the loan due to the increase in inflation.

Describe four factors that can affect the natural rate of unemployment and indicate the impact of each on the value of the natural rate of unemployment in an economy.

i. An increase in unemployment benefits can increase the natural rate of unemployment. ii. An increase in the number of new workers in the labor force increases the natural rate of unemployment. iii. A decline in union membership decreases the natural rate of unemployment. iv. An increase in labor productivity decreases the natural rate of unemployment.

Female—age 68, worked 30 hours per week as a substitute middle school teacher

Employed, part of CPS, possibly underemployed

In comparing the CPI with the GDP deflator, which of the following is not correct?

Both the CPI and the GDP deflator are based on a basket of goods that changes infrequently.

Barry is unemployed because he was laid off by the automobile factory when the economy entered a severe, prolonged recession.

Cyclically Unemployed

Female (head of household)—age 45, worked full time during the month as computer analyst -

Employed part of CPS

Jessica is unemployed because she is in the process of reentering the labor force after taking time off to have a baby.

Frictionally Unemployed

Sandy left her former job at an accounting firm a month ago. She is in the process of interviewing for a similar position at six different accounting firms, although she has not accepted a job yet.

Frictionally Unemployed

Greater access to the Internet leads both potential employers and potential employees to use the Internet to list and find jobs.

Greater access to the Internet would facilitate job searches, reducing frictional unemployment and lowering the natural rate of unemployment.

What can you deduce if the actual rate of unemployment exceeds the natural rate of unemployment?

If the actual rate of unemployment is greater than the natural rate of unemployment, then some workers are cyclically unemployed and the economy may be in a recessionary phase of the business cycle.

How will the following changes affect the natural rate of unemployment? a. The government reduces the time during which an unemployed worker can receive unemployment benefits.

If the government reduces the time during which an unemployed worker can obtain benefits, workers will be less willing to spend time searching for a job. This will reduce the amount of frictional unemployment and lower the natural rate of unemployment.

Why does inflation have a positive effect on nominal interest rates?

Inflation has a positive effect on the nominal interest rate because individuals and firms care about the real interest rate. If you want a real return of 3% on your savings, then the nominal rate has to be that 3% plus whatever the rate of inflation is. (see the previous answer on the Fisher effect).Real Interest Rate = Nominal Interest Rate - Inflation OR Nominal Interest Rate = Real Interest Rate + InflationIf you want to keep the real interest rate constant at 3% and inflation increases, then the nominal interest rate must increase by the same amount.

Male—age 70, retired

Not in labor force

Male—age 50, laid off last year, did not work or look for work during the month.

Not in labor force - discouraged worker

In the long run, how will the lower time preferences affect the levels of capital and income growth in that nation?

Since Investment is going up from the increase in the supply of loanable funds, then GDP will increase (since I is a part of GDP), and income will grow!

Union membership declines

Since strong unions negotiate wages above the equilibrium level, they are a source of structural unemployment. A decline in union membership will reduce structural unemployment and, with it, the natural rate of unemployment.

More teenagers focus on their studies and do not look for jobs until after college.

Since teenagers have a higher rate of frictional unemployment, this will lower the overall amount of frictional unemployment and lower the natural rate of unemployment.

If the nominal interest rate were 8% and the CPI rose from 125 to 130, what was the real interest rate?

The inflation rate was (130 - 125)/125 = 4%. The nominal interest rate = the real interest rate + the inflation rate. So, the real interest rate = the nominal interest rate - expected inflation. The real interest rate = 8% - 4% = 4%.

What do economists mean by the natural rate of unemployment?

The natural rate of unemployment is the normal unemployment rate around which the actual rate of unemployment fluctuates. It is measured as follows:Natural rate of unemployment = Frictional unemployment rate + Structural unemployment rate

If an improvement in the quality of a good is not fully measured than the consumer price index will overstate the increase in the cost of living.

True

Indexation is the automatic correction by law or contract of a dollar amount for the effects of inflation.

True

Interest rates are usually reported as nominal interest rates.

True

The consumer price index for this year equals Price of Basket Goods and Services This Years/ Price of Basket Goods in this Year x100

True

Female—age 22, not working, applied for positions in retail sales during the month,

Unemployed in labor force, part of CPS

Suppose that you also take out a $1,000 loan at the Cavalier Credit Union. The loan agreement stipulates that you must pay it back with 4% interest in one year, and again, the inflation rate is expected to be 2%. -If the inflation rate turns out to be 3% rather than 2%, who will be helped by this? Why?

You are. You expected to pay a real interest rate of 2% but now you only have to pay a real interest rate of 1%.

How would you respond to a friend who claims that the government should eliminate all purchases that are financed by borrowing because such borrowing crowds out private investment spending?

You might first acknowledge that, other things equal, when the government runs a budget deficit, there is an decrease in the supply for loanable funds (public savings decreases). The decrease in supply raises interest rates and decreases private investment spending. This means that businesses will add less physical capital each year and productivity growth may be slower than it would be if the government had not borrowed to cover its deficit. However, you might then explain that some government purchases are necessary for economic growth. Government funds much of the infrastructure within which the economy operates (for example, the legal framework, the court system, and the communications network), and the government also invests in education, roads, and airports necessary for economic growth.

Male—age 15, worked part time during the month at a restaurant,

although he's employed, not part of CPS or in labor force because of his age!

Samantha invested $2,500 of her savings in a certificate of deposit that pays an annual 4.25% rate of interest. The current annual inflation rate is 5%. Has Samantha made a wise investment from an economic perspective?

has not made a wise investment, as the real interest rate she is earning on this investment is negative. The real interest rate Samantha is earning is computed as follows:Real interest rate = Nominal interest rate - Rate of inflationReal interest rate = 4.25% - 5% = -0.75%

William wants to earn a real annual interest rate on his investment of at least 7%. If the annual rate of inflation is 4%, what is the minimum nominal rate of interest William would be willing to accept on his investment?

must receive a minimum nominal annual rate of interest equal to 11%, which is computed as follows:Real interest rate = Nominal interest rate - Rate of inflation 7% = Nominal interest rate - 4%Nominal interest rate = 11%

The consumer price index is computed using weights based

on a survey of consumers. Of the major categories of goods and services, housing is the largest.

Suppose that the CPI includes two goods, rice and bread which are substitutes. If the year after the base year the price of bread rises relative to the price of rice then

the weight the CPI places on rice will be lower than actual expenditures indicate, so the inflation rate will be overstated.