QUIZ 1: Macro – Winter 2007

Name: ______________________

Section Registered (circle one) F 8:30-11:30 S 9:00-12:00

Question 1

Put answers in the space provided. Calculators are allowed. Answers will be graded on a partial credit scale. Perfect answers with the appropriate documentation of your work will be given the complete score; answers with an intuitive attempt at the correct procedure but a wrong answer will be given 50% credit; answers with a totally incorrect procedure (even if the answer is correct) will be given either 0 or 1 point. This implies that you must show your work to get full credit!!!!

Suppose you were given the following data about average hourly wages of all U.S. employees for the following years. All wages are reported in current year dollars (i.e., 1977 wages are in 1977 dollars, etc.). I also listed the corresponding CPI for those years. These data are actual U.S. wage and CPI data. I picked data from January of each year so the CPI and wage data will correspond to the same time period. The current base year of the CPI is 1982 (CPI in 1982 = 100).

Wages CPI1977 $5.26 58.71992 $10.67 138.02005 $15.91 191.32007 $17.10 203.2

The question we are going to address is the extent to which real wages in the U.S. have changed over the last 30 years and the extent to which the accuracy of the CPI affects the conclusions about changing well being over time (as measured by changes in the average wage within a society).

a) In 2005 dollars, what was the real wage in the U. S. in 1992? Use the CPI to convert all nominal wages into real wages. (4 points)

This question was nearly identical to the example I went through in the supplemental notes. In that example, had you compute real wealth in different years (in 1996 dollars). In this quiz, you need to compute real wages from different years (in 2005 dollars). The mechanics of the problem are exactly the same. This quiz question, given the supplemental notes, was even easier than the question from last years quiz.

Real wage in 1992 = [Nominal Wage in 1992/CPI(1992)] * CPI(2005)= [10.67/138] * 191.3= $14.79 (in 2005 dollars)

b) In 2005 dollars, what was the total growth rate in real wages between 1977 and 2007 (use the exact formula)? (4 points)

For this question, you follow the same procedure as above.

First, convert the 1977 and 2007 wages into 2005 dollars.

i) Real wage in 1977 = [Nominal Wage in 1977/CPI(1977)] * CPI(2005)= [5.26/58.7] * 191.3= $17.14 (in 2005 dollars)

ii) Real wage in 2007 = [Nominal Wage in 2007/CPI(2007)] * CPI(2005)= [17.10/203.2] * 191.3= $16.10 (in 2005 dollars)

Second, compute the growth rate in real wages.

Growth rate in real wages [77-07] = [Real wage (2007)/Real wage (1977)] – 1= [16.10/17.14] – 1= -6.1%

I asked for the total change over the thirty years. But, some people gave the annual change over the 30 years of about -0.2% per year. That is fine as well. c) There is an abundance of evidence suggesting that the CPI inflation rate is biased

upwards. A consensus is emerging that the bias is around 1% per year. The reason is that the CPI does not accurately measure quality improvements in goods (attributing the change in price for a good solely to changes in inflation, on average, not to the fact that the average good is improving in quality over time).

If the CPI inflation rate is actually biased upwards by 1 percent per year, what would be the total real wage growth between 1977 and 2007 if one adjusted for such a bias? You can use the approximation formula if you want – just make sure you adjust the approximation for compounding that occurs from a 1% bias over 30 years. (3 points)

This was the easiest part of the quiz. If the inflation rate was overstated by 1% per year, then over 30 years, the inflation rate would be 34.78 percent lower (1.01)30-1. If the bias is true, the growth in wages would be roughly 34.78% higher than the answer in part b. As a result, the actual change in real wages would be about 28.8%.

Some people used an exact formula which yielded an answer of 26.5%.

Question 2

Last week in class, I told you that the main reason that economists care about high inflation is that it creates uncertainty in the economy. Why does a high inflation rate create uncertainty in the economy? Focus your answer on the lending market. Why can’t lenders and borrowers price this inflation uncertainty? Your answer should not be more than three well constructed sentences. Also, this question has nothing to do with indexing – so indexation should not be part of your answer. (5 points)

High inflation rates are almost always associated with variable inflation rates. As the inflation rate variance increases, the uncertainty over real returns increases. If borrowers and lenders are risk averse, both need to be compensated for the increased risk. Lenders get compensated by charging an increased rate and borrowers get compensated by paying a lower rate. The result is less economic transactions between borrowers and lenders occur.

Question 3

In “Divining the Future” (Economist 1/15/2005), the article said the ECRI (Economic Cycle Research Institute) made a prediction about the U.S. economy in March of 2001. What was that prediction? Your answer should be no more than 7 words. (4 points)

The U.S. economy is entering a recession.