[1] Rules versus discretion: the Barro-Gordon one-shot model of monetary policy Flashcards
The following game, based on Barro and Gordon (1983) focuses on
whether policymakers should [2]
The following game, based on Barro and Gordon (1983) focuses on
whether policymakers should adhere to rules or conduct policy
according to discretion.
We introduce
(i) a Phillips curve specication capturing the relationship between
____ and ____
(ii) a loss function, which specifes the _____ of the __ ___ (or society) over inflation and unemployment.
unemployment
Inflation
preferences
monetary authorities
Now state the Phillips curve relation given by:
U = U^n - a( π - πe )
What does a all the variables represent?
U = Unemployment target U^n = Natural rate of unemployment a = sensitivity of unemployment to inflation gap (π - πe) π = Inflation rate set by monetary authorities πe = expected inflation
The loss function is specified as:
L = [ b (U - kU^n)^2 + π^2 ]
What does a all the variables represent?
What values is k between and why?
L = the level of disutility felt by monetary authorities b = how much policy makers cares about unemployment RELATIVE to inflation kU^n = target level of unemployment π = inflation rage
0 < k < 1 because if k were greater than 1, unemployment would be above it natural rate which is nonsensical
The __ __ set by the monetary authority (π) is a function of the ináation rate ___ by the __ __ ( __ )
Barro and Gordon ask following question: should monetary policy be conducted by __, or according to __ __?
informative to look at e§ect on the loss function (L) and unemployment (U) when the monetary authorities and the private sector behave in di§erent ways
ináation rate
expected
private sector (πe).
discretion
binding rules
Assume monetary authorities announce they will set ináation to zero (π = 0), believed by ___ __ ( __ = __ ).
Monetary authorities then have choice: given private sector expectations are ___ (πe = 0), should they abide by their promise (__), or renege on it (___) [discretion]?
private sector
(πe = 0 ).
fixed
π = 0
π > 0
If πe = 0, then ináation is ___.
Under RULES we have
π …
U …
Under surprise ináation - when the government
CHEATS- we have
π…
U …
positive
π = 0
U = Un
π > 0
U < Un
Now compare loss functions under rules and cheating: clearly: [Ls = SURPRISE ie.Cheating]
LS __ LRule
It is clearly in the interests of the government to …
LS < LRule
It is clearly in the interests of the government to announce zero ináation and cheat than adhere to binding rules:
The private sector endowed with _ _ (stands for?), and there is complete information - __ __ and __ ___common knowledge.
The private sector calculates that if the monetary authorities announce zero ináation (and are not bound by a rule), the ___ __ ___will be too big.
As a result, in the absence of rules (i.e., under discretion) the….
Monetary authorities also know __ __ __ and therefore make adjustments.
What does this mean for Inflation, Unemp and Loss Funciton?
Rational Expectations
Phillips Curve
loss function
temptation to cheat
private sector expects positive ináation ie. cheating
private sector expectations
unemployment remains at its natural level
π = πe
Loss function: LRat > Lrule
Exactly same as binding rule except greater loss func
What if the monetary authorities still follow a rule given the private sectorís rational expectation of
πe = ab(1 k)U^n?
Economy will be… Realised Inflation will be…
Unemp will be .. while …
Value of Loss Function is…
In short the economy will be ëdisináatedí: realised ináation will be below what the private sector expects.
Unemployment pushed above its natural rate, while ináation positive
In terms of the loss function, value of L is higher than any other scenario
LDis denotes the loss function for the case under disináation where the monetary authorities choose not to ináate the economy
Summary of the loss functions:
Give size order?
What is the Best outcome obtainable despite what being most preferred?
LS < LRule < LRat < LDis
LRat best obtainable despite Ls being most preferred
Why is Ls Impossible?
Monetary authories have to generate a inflation surprise and this requires the private sector believing that zero inflation will be set ( πe = 0).
Yet this is impossible: under discretion (in the absence of rules) the private sector has full information about the central bank loss function, knows the structure of the PC and has RE.
This means that in practice, even though the monetary authorities may announce zero ináation, they will not be believed.
Why is LRule not the next best outcome? (where monetary authorities adhere to the binding rules)
The best obtainable solution is therefore LRat: even though RULES are preferred to DISCRETION, in the absence of binding rules, the RE outcome occurs: this is the “third best” of the four possible outcomes.
Able to draw Loss functions on Graph? x2
show highest obtainable outcome
slide 17
What is Time-Inconsistent MP mean?
Time-inconsistency is the problem that arises when a decision maker, especially a policymaker, prefers one policy in advance but later enacts a different one.
Time-inconsistency describes situations where, with the passing of time, policies that were determined to be optimal yesterday are no longer perceived to be optimal today and are not implemented. … However, time-inconsistency can affect more than just the average rate of inflation that prevails in the economy.
