1) REAL VALUES a) In 2005, Mr. Jones received a monthly social security check fr
ID: 1215707 • Letter: 1
Question
1) REAL VALUES
a) In 2005, Mr. Jones received a monthly social security check from
the government of $300. If the inflation rate was 7% during 2005,
what will his monthly check be in 2006 assuming the government
indexes benefits?
_________________
b) In 2006, my salary was $100,000. The CPI was 125 (with a base
year of 1990). What was my real salary in 2006 in 1990 prices? In
other words, what would my salary have been if prices had not
changed since 1990?
_________________
c) In 1960, Joe's father earned $4.50 per hour working in a factory.
Today, Joe earns $35.00 working in the same factory. If the
CPI was 20 in 1960 and 160 today, who received the higher real
wage, Joe or his father?
_________________
d) Last year, the inflation rate was 12% and my nominal salary
increased by 9%. What was the growth rate of my real salary?
_________________
Was I better off at the beginning or at the end of last year?
_________________
e) REAL INTEREST RATES
If the nominal interest rate is 9% and the expected inflation rate is 7%,
what is the real interest rate?
Explanation / Answer
Q1 (a) Value of monthly check of Mr. Jones in 2005 = $300
Inflation rate in 2005 = 7% or 0.07
It has been provided that government indexes benefits. This means that government enhances the value of social security check as per the inflation rate.
So,
Value of monthly check in 2006 = $300 + [0.07 * $300] = $300 + $21 = $321
Thus, in 2006, Mr Jones will receive a monthly check of $321 from government.
(b) Salary in 2006 = $100,000
CPI in 2006 = 125
Base year = 1990
CPI in base year is always 100.
CPI in 1990 = 100
Calculate real salary in 2006 in 1990 prices -
Real salary = Salary in 2006 *(CPI in 1990/CPI in 2006)
= $100,000 * (100/125)
= $80,000
The real salary in 2006 in 1990 prices was $80,000.
(c) Wage of Joe's father in 1960 = $4.50 per hour
Wage of Joe today = $35 per hour
CPI in 1960 = 20
CPI today = 160
CPI in base year = 100
Calculate real wage rate of Joe's father -
Real wage = Nominal wage * (CPI in base year/CPI in 1960)
= $4.50 * (100/20)
= $22.5
The real wage rate of Joe's father is $22.5 per hour.
Calculate real wage rate of Joe -
Real wage = Nominal wage * (CPI in base year/CPI in 1960)
= $35 * (100/160)
= $21.875
The real wage rate of Joe is $21.875 per hour.
The Joe's father received higher real wage.
(d) Inflation rate = 12%
Growth rate of nominal salary = 9%
Calculate growth rate of real salary -
Growth rate of real salary = Growth rate of nominal salary - Inflation rate = 9% - 12% = -3%
The growth rate of real salary is -3%.
The real salary has grown by -3%. This means that in real terms salary at the end of the year is less than it was at the beggining of the year.
So, I was better-off at the beginning of the last year.
(e) Nominal interest rate = 9%
Expected inflation rate = 7%
Calculate real interest rate -
Real interest rate = Nominal interest rate - Expected inflation rate = 9% - 7% = 2%
The Real interest rate is 2%.
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