Economics 345 Prof. Irina Telyukova Fall 2008 Homework Assignment 1 SOLUTIONS

1. For this question, you get to do economic data research! You are going to need data on inflation – the Consumer Price Index – which you can find on the Bank of Canada website, which is linked on our course’s webpage. If you are a visual learner, you may it helpful to graph the series (for example, in Excel). • What is the difference between total CPI and core CPI? – Do some research of

your own to find out.

Total CPI – Consumer Price Index – measures the average price in the economy using a basket of goods that consumers typically buy. These goods represent every possible commodity that households buy – for example, food items, clothes, gasoline, durables (washing machines and cars), etc. However, items such as food and gasoline tend to have particularly volatile prices, so we have some alternative measures of the CPI that account for that. The core CPI takes out the prices of food and gasoline from the consumer basket, thus allowing us to see how prices and inflation of all but the most volatiles goods are doing. It helps understand whether the traditionally more stable part of the economy is suffering from inflation when food and gas prices are.

• What have been the trends in inflation in Canada in 2006, 2007 and 2008, in

terms of core and total CPI? Are the trends the same for core and total CPI? If you look at the Bank of Canada website, you find data on the core and total CPI here: http://www.bank-banque-canada.ca/en/cpi.html They show both the level of the CPI as well as percentage change over the same month last year. The percentage change is the way to measure inflation. We graph these data:

Inflation: % change Over Year Ago in Core and Total CPI

0

0.5

1

1.5

2

2.5

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3.5

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Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08

Total CPI Core CPI

From the graph, you can immediately see that the red line (total CPI) is much more volatile than the green line (core CPI). You can see, moreover, that since April 2008 or so, total CPI has been on a dramatic increase, from around 1.5% to almost 3.5% , while core CPI has been completely flat. (Note: you did not need the graph to conclude the same things as above – you could look at numbers for the two CPI series and find the same things; for example, since April 2008, core CPI annual percent change has been stable at 1.5%, while total CPI has been rising, from 1.7 to 3.4%). Finally, notice this: constant core inflation does NOT mean that prices have not been rising – instead, they have been rising at a constant rate per month.

• What might be contributing to the current inflation trends? If core and total

CPI are behaving differently now, why might that be?

Core inflation has been stable, while total inflation has been rising. What this tells us is that the recent rise in inflation is primarily due to the increase in gasoline and food prices. Gas and food prices, in turn, have been increasing because of rising prices of crude oil and other commodities (e.g. corn – due to heavy investment in ethanol production), all of which affects, obviously, gas directly and food either directly or indirectly.

2. When was the most recent recession in Canada?

Quickest way to answer this is by looking at figure 1-4 in your book, where the graph of money growth is shown, along with shaded areas for recessions. The most recent Canadian recession was in the early nineties, and lasted less than a year. We can be a bit more formal about this, here is the graph of the annual percent change of quarterly real GDP (in 2002 dollars) – data taken from Statistics Canada (UBC has access through the library, if you are interested). The graph (below) helps us see that the two major recessions in recent history were in the early 1980’s and the early 1990’s (specifically, 1982-1983 and 1991-1992). Recall that the official definition of a recession is falling output for at least 2 consecutive quarters.

Canada Real GDP: Annual Percent Change

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-0.04

-0.02

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0.02

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0.1

1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

3. Mishkin and Serletis, Chapter 1, p. 13, questions 4, 5, 7, 13, 14.

(4) See answer in the book. (5) Open answer. Examples could be debit and stored-value cards, innovations in the mortgage market (if you or your family own a home), electronic bill payment, and the like. (7) To accept deposits and make loans. (13) The main effect is on exports and imports. It makes British goods more expensive relative to Canadian goods. Thus Canadian businesses will find it easier to sell their goods in Canada and abroad and the demand for their products will rise.

(14) Answer in the book. When it refers to the dollar, it means Canadian dollar.

4. Mishkin and Serletis, Chapter 2, p. 42, questions 1, 6, 7, 8, 10, 11, 14.

(1), (7), (11) Answer in the book (6) You would rather hold bonds, because bondholders are paid off before equity holders, who are the residual claimants – so if the company goes out of business, you have a higher chance as a bondholder to get your funds back.

(8) Open answer. One possibility: if you have ever tried to take out a loan, or apply for a credit card, you would have encountered this problem – you would be subject to very high scrutiny by the lender. On the flip side, if you have ever made a loan, you might have faced this problem as well. (10) The basic problem (we call it a principal-agent problem in economics) is that while the boss is not looking, the employee could be surfing the web/talking on the phone/ generally not working hard enough. So they might not always be working as hard as you would like. More starkly, they could in principle be stealing (office supplies?) from you. If you happened to be running a large investment house, there could be danger of your workers putting your funds at risk by investing too riskily, or committing other kinds of fraud – not unheard of in the corporate world. (14) Risk sharing leads to the creation of assets with characteristics that private investorse are comfortable with. This benefits financial intermediaries, since by selling these assets they can use the acquired funds to purchase other assets, thus making profit.