A3_F11_Sol - Econ 204 Instructor: J. Li Page 1 of 10...

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Unformatted text preview: Econ 204 Instructor: J. Li Page 1 of 10 ASSIGNMENT 3 ANSWERS Mar 2011 1. Empirical Part: Interest Rate (a) Identify: series label. +0.5 for each series All-item CPI (2002=100): V41693271 3-month T-bill rate: V122531 (b) Given: CPI and 3-mo T-bill rate over 1980-2010. (1) Find: ex post real interest rate. t t t t t P P P i r ) _ ( 100 1 +1 The nominal interest rate reported is the 3-Month Government of Canada Treasury Bill. The base frequency for this series is monthly; annual numbers have been constructed by averaging over the year. The annual inflation rate is derived from the Consumer Price Index (All Items, 2002=100).The real interest rate is calculated as an ex post real interest rate using the Fisher equation. (2) Plot: The series used for operational purposes by the BoC. +1 for each series The figure below plots the real interest rate, the nominal interest rate and the inflation rate for Canada over the period 1980–2010. (c) (1) Inspect: interest rates in 2000s. The notable feature of the real interest rate series is that in the late 2000s they are very low and, for the early 2000s and part of the second half of the decade they are negative. +1-5.00 0.00 5.00 10.00 15.00 20.00 Annual Inflation Real Interest Rate 3-Month Nominal Interest Rate Year Real Interest Rates for Canada (constructed from 3-month T-Bill and All-Item CPI) Econ 204 Instructor: J. Li Page 2 of 10 (2) Explain: low real interest rates of the 2000s. The most straightforward explanation for these negative real interest rates is that inflation expectations were consistently too low. +0.5 Recall that the calculated real interest rates are ex post ; that is, they are calculated using actual inflation not the inflation rate that borrowers and lenders expected. If inflation was consistently higher than expected inflation, nominal interest rates would have not fully compensated for the inflation that occurred. One effect of this is to make borrowers better off at the expense of lenders; that is, there is a transfer of resources from lenders to borrowers. Although this seems to be at least part of what happened, it does raise the question as to how people systematically under-predicted inflation. The other explanation for the low real interest rates is that it reflects the equilibrium outcome of saving and investment decisions. +0.5 For example, low demand for investment would, all else equal, contribute to lower real interest rates. This leads directly into the next question, the likely effect on the economy. (3) Speculate: the effect of low real interest rate on the economy? We can also ask what the effects of these low interest rates were on the level of aggregate demand in the economy; a natural prediction would be that the low interest rates would lead to higher aggregate demand through consumption and investment....
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This note was uploaded on 01/27/2012 for the course ECON 204 taught by Professor Beryl li during the Spring '11 term at University of Victoria.

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A3_F11_Sol - Econ 204 Instructor: J. Li Page 1 of 10...

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