Problem_Set_5_Solutions - Economics W3213 Spring 2010 Bruce...

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Economics W3213 Spring 2010 Bruce Preston Problem Set 5 Solutions Short Answer Questions Indicate whether you think the following statements are true, false or uncertain. Support your answer by giving all necessary reasoning and calculations. Credit will not be given for a lucky guess. 1. Rules-based policy making is inferior to discretionary policy making as it prohibits policy responding to special circumstances. Solution: False From the Barro-Gordon model we know that rules may in fact be superior to discre- the economy by generating in²ation are anticipated by the public. Because of these anticipations, in²ation in equilibrium is higher than it otherwise would be. What is fas- cinating about this model is that the government±s actions are well intentioned. Given low in²ation expectations on the part of the public it is optimal for the government to create and expansion along with some in²ation. Over time this leads the public to ques- tion its low in²ation expectations leading to higher in²ation in equilibrium. This is the discretionary equilibrium (or rational expectations equilibrium) of the Barro-Gordon model. What we showed in class is that there may be advantages to having the gov- ernment commit to a rule for the determination of in²ation. In particular committing to a rule of the form t = at all times leads to better welfare outcomes than the discretionary equilibrium. 2. In the AD-AS model developed in class, the assumption of adaptive expectations gener- in consumer sentiment. However, a credible central bank with a reputation for sound can mitigate these output losses. Solution: Uncertain In the AD/AS model the assumption of adaptive expectations leads to persistent dy- namics even when shocks are only temporary. In this case, a temporary collapse in demand from worsening consumer sentiment shifts the AD curve to the left. Over time, under adaptive expectations, the AS begins to shift down and to the right as in²ation is lower. If the demand shock lasts only one period, so the AD curve shifts back to 1
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its original position, the AS will still be lower and to the right of its original position. adjustment can take many periods, though note here the output gap is positive once the AD curve returns. This may actually make the output losses small, because the initial negative output gaps are o/set later by positive output gaps. In the case of anchored expectations, the AS curve never shifts. Hence, the output gap is di/erent from zero
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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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Problem_Set_5_Solutions - Economics W3213 Spring 2010 Bruce...

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