1Prof. CostainEcon. Theory IVThe Barro-Gordon model of rules versus discretionThere are many situations in which one economic agent (the government forexample) has an incentive to deceiveanother economic agent. For example, it is oftenobserved that politicians make extravagant promises during election campaigns whichthey 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, orworse. So as economists, we would like to understand what occurs if:(1)Agent A wants to deceive agent B(2)But agent B knowsthis.The temptation to inflate away the debt.In a macroeconomic context, the government suffers a temptation to deceive thepublic when it chooses the rate of inflation. Why? Because many governments financetheir deficits by selling bonds with a fixed nominal interest rate i. The nominal interestrate that the public accepts must give an adequate expectedreal interest rate, taking intoaccount expected inflation:This equation shows that the nominal interest rate ithe government must pay on itsbonds depends on the public’s expectations about inflation pe, and on the real interestrate redemanded by people who buy bonds. So the government can sell bonds with alownominal interest rate only if the public expectslow inflation.On the other hand, afterit has sold bonds to the public, the realinterest rate paidby the government depends on the actual inflation rate:The real interest rate ractually paid by the government is the nominal interest rate iminus the rate of inflation pactually chosen by the government. So the governmentends up paying a lower real interest rateif inflation is higher. Thus we notice:Conclusion.The government benefits if people expect low inflation.But the government also benefits if the trueinflation rate is high.In fact, if we combine the last two equations, we get:We see that the real interest rate rthat the government actually pays is lowerthanexpected whenever p>pe: that is, whenever inflation is higher than expected. Soanother way of describing the situation is:eerip+=p-=irppp-+=-=eerir
has intentionally blurred sections.
Sign up to view the full version.