Question

FRANKFURT—European Central Bank President Mario Draghi Thursday signaled that the governing

council may provide more stimulus at its next meeting in March, noting that the outlook for inflation had weakened “significantly.”

It seems like the macroeconomic ‘buzzword’ Quantitative Easing (QE) has returned – the Fed in the US conducted three rounds of QE with the third jokingly referred to as  “QE infinity.”  As we know, the Fed is done with QE, at least for now. The ECB earlier in 2015 announced similar plans (as above).  Note that the ECB has an inflation target of 2%, just like the Fed.

Use the following link to answer part a)

Click https://research.stlouisfed.org/fred2/series/CP0000EZ17M086NEST for CPI data from the Eurozone!

a) (5 points) Calculate the rate of inflation for the Eurozone for the most recent two years: from 11/13 – 11/14 and from 11/14 to 11/15

We now move on to the US.  You will need to use the following links to answer this question. 

Nominal one year rates (i)  https://research.stlouisfed.org/fred2/data/GS1.txt             

Price index  CPI (P)     https://research.stlouisfed.org/fred2/data/CPIAUCSL.txt

Expected Inflation https://research.stlouisfed.org/fred2/data/MICH.txt

In this part of question 2, we are going to compare the most recent one year real interest rates in the US – both ex-ante and ex-post.

A couple notes are in order.

i) Expected inflation data is one year hence – so for example,  expected inflation for the period from July 2010 to July 2011 is given in July 2010 and if you view the data, the expected inflation during this time is 2.7% = π^e.

ii) To calculate the actual rate of inflation, for example, during the July 2010 to July 2011 period you need to take the percent change in P = %Δ P.  Using the CPI data, we have the

price index equaling 217.7 in 7/2010 (beginning of August given the end of month data) and 225.6 in 7/2011 (end of July, 2011).  Note, this is a 12 month period. The actual rate of inflation during this time is 3.63% = π

iii) When using the one year nominal interest rate to calculate the all important real rate(s) of interest we need to be careful.  For example, using the same one year time period (July 2010 – July 2011) we simply use the one year rate given as of July 2010.  Think of buying the bond in July 2010, putting it in a safety deposit box (or under your mattress, a coffee can, etc.) and then cashing it in when it matures in July 2011 (you get your principal times whatever the nominal interest rate is).  In viewing the data, the one year rate in July 2010 is 0.29%.  So clearly (and by design of the Fed), both the ex-ante and ex-post real rates are negative during this period and differ because expected inflation was not equal to actual inflation.

b) (5 points) Using the most recent data (from 12/14 – 12/15) calculate the ex-post real interest rate.

c) (5 points) Given the most recent data, what is the ex-ante one year real rate of interest?

d) (5 points) Assuming that the Fed feels that there is still significant slack in the economy, that is, they wish that consumption was higher, which real interest rate does the Fed want the consumer to consider, the ex-post or the ex-ante? Explain.

We discussed the evils of deflation.

e) (10 points) From a macroeconomic perspective, why is deflation so bad?  Please refer to consumer behavior and the corresponding behavior of firms in a deflationary environment. Please explain completely.

f) (10 points)Now discuss the fact that persistent deflation is the central bank’s worst nightmare Why is this environment such a nightmare for the central bank and monetary policy and why is persistent deflation such a nightmare? Explain using the Fisher equation for the real rate of interest and refer to both the ex-post and ex-ante real rate of interest.

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