Barro_Gordon_Notes - Prof. Costain Econ. Theory IV The...

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1 Prof. Costain Econ. Theory IV The Barro-Gordon model of rules versus discretion There are many situations in which one economic agent (the government for example) has an incentive to deceive another economic agent. For example, it is often observed that politicians make extravagant promises during election campaigns which they are later unable to fulfill. But, people don’t really believe these promises, do they? Everyone seems to understand that politicians’ promises are usually exaggerations, or worse. So as economists, we would like to understand what occurs if: (1) Agent A wants to deceive agent B (2) But agent B knows this. The temptation to inflate away the debt. In a macroeconomic context, the government suffers a temptation to deceive the public when it chooses the rate of inflation. Why? Because many governments finance their deficits by selling bonds with a fixed nominal interest rate i . The nominal interest rate that the public accepts must give an adequate expected real interest rate, taking into account expected inflation: This equation shows that the nominal interest rate i the government must pay on its bonds depends on the public’s expectations about inflation p e , and on the real interest rate r e demanded by people who buy bonds. So the government can sell bonds with a low nominal interest rate only if the public expects low inflation. On the other hand, after it has sold bonds to the public, the real interest rate paid by the government depends on the actual inflation rate: The real interest rate r actually paid by the government is the nominal interest rate i minus the rate of inflation p actually chosen by the government. So the government ends up paying a lower real interest rate if inflation is higher. Thus we notice: Conclusion. The government benefits if people expect low inflation . But the government also benefits if the true inflation rate is high . In fact, if we combine the last two equations, we get: We see that the real interest rate r that the government actually pays is lower than expected whenever p > p e : that is, whenever inflation is higher than expected . So another way of describing the situation is: e e r i p + = p - = i r p p p - + = - = e e r i r
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2 Conclusion. The government pays a lower real interest rate on its debt if it deceives the public by choosing more inflation than the public expects. The temptation to raise aggregate demand. In Keynesian macroeconomics, the government has a second reason to deceive the public when it chooses the inflation rate. If prices are sticky, then the government can temporarily raise output by increasing the money supply unexpectedly . Remember that an increase in the money supply shifts the LM curve right (holding prices fixed), while an increase in the price level shifts LM left (holding the money supply fixed): If firms perfectly anticipate government behavior, with sufficient time to adjust their prices, then a change in the money supply is neutral. For example, a 5% increase
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This note was uploaded on 02/27/2011 for the course ECONOMICS 201 taught by Professor P during the Spring '11 term at Columbia College.

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Barro_Gordon_Notes - Prof. Costain Econ. Theory IV The...

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