topic 5 - rational expectations 2 Flashcards
what are the two main reasons why we cannot dispense from studying rational expectations?
they are pratically ubiquitous. this can be understood as: the applicatiabilty of RE is not as universal as their ubiquity would give us to believe however the opposite is also arguably true. the RE are not inapplicable or that implausible in all possible contexts so much like constrained optimisation is not applicable in all cases this does not imply that we can dispense with knowing how to do it.
2) the RE is central to a model that has shaped monetary policy arrangement around the world since the early 1980s. making sense of policy choices during that time without reference to this model is practically impossible because those choices were made with that model in mind.
what does the sargent and wallace (1976) policy ineffectiveness proposition show?
it shows that output deviates from its equilibrium level only because of random shocks and because of policy surprises (in the exceeding rare cases where the policy maker may change inflation target and not let anyone notice it
how can the sargent and wallace policy ineffectiveness proposition be drawn on the three equation model and what is the conclusion?
you draw a graph whihc shows that equilibrium output deviates from its previous level because of random shocks and policy surprises only. if a policy of disinflation were to be announced then the MR curve will shift down from MR to MR1. rational agents will correctly perceive this change and would therefore adjust their expected inflation to a new lower inflation target so that the IAPC goes down by the exact same amount and so output will remain the same. as a result disinflation will be costless
what was the result of the thatcher government attempting the sargent and wallace policy ineffectiveness proposition??
they tried such a policy holding the belief that disinflation would be costless however the result certainly disproved the proposition as a massive recession ensued. disinflation is in general costly and a model that says otherwise serves little purpose and may be dangerous
why is the policy ineffectiveness proposition implausible?
it is implausible because it can only justify disinflation being costly in terms of output and employment in two ways: 1) the policy change is a surprise which is deeply implausible and 2) the policy change is not credible
what are the three assumptions for which the sargent and wallace proposition rests on?
1) rational expectations
2) perfect price flexibilty
3) perfect wage flexibility.
any minor violations of any one of the three will invalidate it even on its own terms.
why should the policy maker not target an output level that is beyond the equilibrium?
the answer is an elaboration of the barro gordon model where the assumption is made that the policy maker does intend to achieve such a higher level of output as reflected in his her output objective in the loss function.
why is there a desire to achieve a higher level of output as reflected in his/her output objective in the loss function?
1) non satiation: more is always better. possibly too trivial a rationale but plausible nonetheless.
2) there are intractable problems of competition policy in the economy that make it operate below its potential. addressing them directly is politically impossible so an implicit target of output to the right of equilibrium is adopted instead. plausible but not that compelling.
the policy maker is seeking to be reelected and a boom or a reduction in unemployment is the best chance of obtaining a boost in popularity in the run up to the election. this is by far the most important reason
why is the barro gordon model useful?
- As stated above it is impossible to make sense of recent monetary history, as most countries adopted policies that were, one way or another, intended as answers to the Barro Gordon problem. Right or wrong it cannot be ignored and in that respect it is useful.
- It is a theoretically sharp model that calls for sharp solutions that have to work even in abstract game-theoretic settings. If a solution can work in such a context, all the more can it work once its stringent assumptions are relaxed as it is the case in actual policy-making.
why is the barro gordon model wrong?
- It has engendered the primacy of monetary considerations and the achievement of the inflation target to the detriment of any other objective in a central bank mandate. In this sense it can be accused of being a form ofextreme monetarism but this is a misnomer.
- For instance, an incentive is generated for the central bank to disregard any output objective and preferably interpret shocks to output as supply shocks. A bias for inaction is generated once the inflation target is achieved.
- Such inaction is doubly deleterious because, the equilibrium level of output is never a constant in actual policy-making but is forever changing at a different pace. So the stark terms of the model can be be very misleading and deprive the economy of potential non-inflationary growth.
- The starkly reduced terms of the central bank mandate, also create a situation whereby the central bank prefers to be blind to other potential factors of instability, the obvious example being that of financial instability. It has been argued that the success at reducing inflation within the terms of the Barro Gordon framework has generated the incentives for greater and greater financial instability that has ultimately led to the Financial Crisis of 2007/2008.
what is the inflation bias?
the inflation bias is defined as the extent to which expected inflation (pe) differs from the announced inflation target (pT ) stated by the policy maker, and is therefore equal in this case to: k/ab>0 where k is the output the government wants above equilibrium output
what is the process of the barro gordon model?
the government annouces a target rate of inflation. at this target inflation, it desires a output above the equilibrium output at y_e+k . if firms and households believed the government they would sign contracts with this expected inflation rate.If the government followed through on its announcements the economy would find itself at point A in the diagram, which represents the commitment equilibrium. But after inflation expectations are set, the Government faces the temptation to exploit the (given) Phillips curve and expand output towards its target which, again, is above full employment, in order to achieve a higher indifference curve. This is point B in the diagram, a cheating equilibrium as the Government reneges on its original commitment, determined by the condition of tangency between the (given)Phillips curve going through point A and the best possible indifference curve.
But wage and price setters (households and firms) know that the government, once expectations are locked in, will be tempted to do that.They form expectations of government’s actions by minimising the loss function exactly as the government would do:This is point C in the diagram where agents’ expectations are validated, output is at full employment and the Government is frustrated in its attempt at reaching its target level of inflation. The point is determined by the condition of tangency between the indifference curves and one Phillips curve so that the tangency point happens to be exactly above the equilibrium level of output at a higher inflation rate
what is the game theoretic interpretation of the barro gordon model?
The game is being played by households and firms on one side and the policy maker on the other. (it is a version of the Prisoners’ dilemma) There are two Nash equilibria: point A and point C. But point C is clearly Pareto sub-optimal.
what are the three solutions to the barro gordon model?
reputation and delegation, and delegation with regulation about expanding output
how is reputation a solution to the barro gordon model
If the game is repeated a number of times, and point A is delivered, the policy maker will earn a reputation to deliver on its promises and will be believed
