homework1 2010 - The public try to set wage inflation so as...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
ECN/APEC 7240 Spring 2010 Homework 1 Due 1/20/10 1) Kydland and Prescott (1977). Consider a model of inflation and unemployment where unemployment u t is determined by the Phillips curve ) ( t t n t w U u - - = π θ , where U n is the natural rate of unemployment, > 0 is the slope of the Phillips curve, t is the rate of inflation for consumption goods, and w t is the rate of wage inflation. Thus, unemployment is a decreasing function of unexpected inflation, meaning inflation in excess of what the public sector has anticipated in writing wage contracts for the next year. Since w t - t is the rate of change of the real wage, unemployment is an increasing function of the rate of change in the real wage. The central bank has some measure of control over inflation. Let x t be the target rate of inflation. Then t = x t + z t where z t ~ N (0, σ 2 ). The central bank chooses its target in order to minimize its loss function ] ~ ~ [ 2 2 t t cb u E L α + = , for > 0—i.e. the central bank tries to minimize both unemployment and inflation.
Background image of page 1
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: The public try to set wage inflation so as to minimize its loss function ], ) ~ [( 2 t t p w E L-= i.e. so that wage inflation matches the rate of inflation for consumption goods. Assume that both the public and the central bank know each others loss functions and the Phillips curve. a) Suppose the central bank sets x t before the public sets w t . Determine the optimal policy for both. This is known as the Ramsey equilibrium. b) Now suppose the public sets w t before the central bank sets x t . Determine the optimal policy for both. This is known as the Nash equilibrium c) Compute the central banks loss function for both equilibria, and show that it is higher for the Nash equilibrium than for the Ramsey equilibrium. d) Explain how it is possible that the central bank achieves a worse outcome if it employs more information in its decision making....
View Full Document

This note was uploaded on 01/09/2011 for the course ECON 7140 taught by Professor Kutler during the Spring '10 term at Utah Valley University.

Ask a homework question - tutors are online