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Select Topics in Macroeconomics – 2012
Questions and Answers
Section A
Question 1
The monetary policy makes wishes to minimize social welfare loss, which can be expressed as:
𝐿 = 0.5 𝑎 (𝜋 − 𝜋 ∗) + 0.5 (𝑦 − 𝑦 ∗)
Where π is the inflation rate, π ∗ is the socially optimal level of inflation, y is the level of output, and
y* is the social optimal output. The economy can be described by the aggregate supply equation:
y = y + b(π − π )
Here, y is the natural level of output, while π is society’s expectation of inflation. If we assume that
the public rationally form inflation expectations π = 𝐸[π], then a time inconsistency problem
arises. The monetary policymaker would prefer for society to set their expectation of inflation equal
to their target rate. However, if society has a knowledge of the monetary policy maker’s loss
function, they will know that the monetary policy maker will choose to set inflation slightly above
this level. This is because the policymaker also has a preference for higher output. Thus, they will set
their expectations slightly above the socially optimal level.
In particular, we can calculate their inflation expectation as 𝜋 = 𝜋∗ + (𝑦 ∗ − y), which is
unambiguously greater than the socially optimal level of inflation. A lack of commitment results in
inflation bias because, if the policymaker were able to commit to setting inflation at the socially
optimal level, then society would set their expectations equal to the socially optimal level.
One possible solution to the inflation bias is to completely abandon monetary discretion, and set
monetary policy before society set their inflationary expectations. However, this means that the
policymaker is less able to adjust to unexpected shocks when they occur. There is a tradeoff
between flexibility and credibility.
Another solution is to give the central banker person incentives to prevent inflation bias. Then, by
have a preference for inflation below the socially optimal level, this will eliminate the inflation bias.
However, a problem with this is that it may be hard to translate these incentives into financial
penalties or firing requirements.
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
Select Topics in Macroeconomics – 2012
Questions and Answers
Section A
Question 1
The monetary policy makes wishes to minimize social welfare loss, which can be expressed as:
𝐿 = 0.5 𝑎 (𝜋 − 𝜋 ∗) + 0.5 (𝑦 − 𝑦 ∗)
Where π is the inflation rate, π ∗ is the socially optimal level of inflation, y is the level of output, and
y* is the social optimal output. The economy can be described by the aggregate supply equation:
y = y + b(π − π )
Here, y is the natural level of output, while π is society’s expectation of inflation. If we assume that
the public rationally form inflation expectations π = 𝐸[π], then a time inconsistency problem
arises. The monetary policymaker would prefer for society to set their expectation of inflation equal
to their target rate. However, if society has a knowledge of the monetary policy maker’s loss
function, they will know that the monetary policy maker will choose to set inflation slightly above
this level. This is because the policymaker also has a preference for higher output. Thus, they will set
their expectations slightly above the socially optimal level.
In particular, we can calculate their inflation expectation as 𝜋 = 𝜋∗ + (𝑦 ∗ − y), which is
unambiguously greater than the socially optimal level of inflation. A lack of commitment results in
inflation bias because, if the policymaker were able to commit to setting inflation at the socially
optimal level, then society would set their expectations equal to the socially optimal level.
One possible solution to the inflation bias is to completely abandon monetary discretion, and set
monetary policy before society set their inflationary expectations. However, this means that the
policymaker is less able to adjust to unexpected shocks when they occur. There is a tradeoff
between flexibility and credibility.
Another solution is to give the central banker person incentives to prevent inflation bias. Then, by
have a preference for inflation below the socially optimal level, this will eliminate the inflation bias.
However, a problem with this is that it may be hard to translate these incentives into financial
penalties or firing requirements.
