W9P4 - Notebooklm Flashcards
What is the central idea behind Ricardian Equivalence?
With rational agents, a change in taxes will not affect the level of spending if government spending is constant because agents anticipate future tax adjustments to offset the current change. Agents understand the government’s intertemporal budget constraint.
According to the lecture, what is the Lucas Critique?
): It is not possible to estimate the response of agents and the economy to a policy change by simply using past data because agents’ behaviour depends on the policy rule and they can change their behaviour in response to a new policy. Estimated coefficients based on past data may not hold under a new policy regime. The estimated coefficient depends on the policy rule and how agents form expectations.
Explain the concept of Time Inconsistency as discussed in the lecture.
Time inconsistency occurs when an action that seems optimal today might not be optimal in the future, leading to a change in behaviour. Rational agents can anticipate this, undermining the credibility of initial announcements.
How does the example of negotiating with terrorists illustrate Time Inconsistency?
A government might announce it won’t negotiate with terrorists to deter hostage-taking. However, once hostages are taken, there’s an incentive to deviate and pay ransom. Rational terrorists might anticipate this and take hostages anyway. A rule against negotiation can enhance credibility.
What is the time inconsistency problem in the context of monetary policy?
A central bank might announce low future inflation, leading to lower inflation expectations. However, once these expectations are low, the central bank has an incentive to increase inflation to reduce unemployment (as described by the Philips curve), deviating from its initial announcement.
How can a fixed rule help address the time inconsistency problem in monetary policy?
A credible fixed rule, such as a strict inflation target, can align inflation expectations with the central bank’s commitment. Under a credible 0% inflation rule, expected inflation is 0%, and unemployment is at the natural rate.
What is the outcome under discretionary monetary policy with rational agents, according to the lecture?
Under discretion, the central bank optimizes inflation based on a loss function, and rational agents anticipate this. Inflation expectations will equal the actual optimal inflation rate, resulting in a higher inflation rate without lower unemployment compared to a fixed rule. This outcome is worse due to the time inconsistency problem.
What are some mechanisms, short of a strict fixed rule, that can enhance a central bank’s credibility?
Mechanisms like requiring the central bank governor to explain deviations from targets to the government can help increase credibility and mitigate the time inconsistency problem.
