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Econ2035 Chapter 16 12 7 11 (scored 92%)

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Department
Economics
Course
ECON 2035
Professor
All Professors
Semester
Fall

Description
Econ203512711Chapter16MonetaryInstitutionsandStrategiesITimeConsistencyandInflationRationalExpectationsandthePhillipsCurveeoPhillipsCurveppapInflationpExpectedinflationTheoutputgapthepercentagedeviationofoutputfrompotentialaAcoefficientshowinghowstronglyoutputaffectsinflationoTherearetwoleadingtheoriesofinflationexpectationsOnetheoryisadaptiveexpectationsorbackwardlookingexpectationswhichsaysthatexpectationsoftheinflationratearedeterminedbypastinflationExpectedinflationequalsinflationoverthepreviousyearepp1oTheothertheoryrationalexpectationssaysthatpeoplemakethebestpossibleforecastsoffutureinflationbasedonallavailableinformationoFirmsbasetheirpriceincreasesontheincreasestheyexpectfromotherfirmsIfexpectationsaremistakenfirmssetthewrongrelativepricesandthisreducesprofitsSowhenfirmschoosepricestheyhaveincentivestoforecastinflationaswellaspossibletoformexpectationsrationallyTheTimeConsistencyProblemoAtimeconsistencyproblemcanariseinmanycontextsItoccurswhensomeonehasincentivestomakeapromisebutthentorenegeonthepromisebecauseoftheseincentivesothersdontbelievethepromiseoSupposeagovernmentwantsfirmstobuildfactoriesmakingtheeconomymoreproductiveThegovernmentmightencouragethisinvestmentbypromisingnottotaxfirmsprofitsfromthefactoriesButthispromiseinnottimeconsistentOncethefactoriesarebuiltthegovernmentwillbetemptedtoenacttaxestoraiserevenueKnowingthisfirmsmaynotbuildthefactoriesHowtheTimeConsistencyProblemIncreasesInflationoIna1977paperbyFinnKydlandofCarnegieMellonUniversityandEdwardPrescottthenUniversityofMinnesotaoAccordingtoRylandandPrescottthetimeconsistencyproblemexplainswhycentralbankssometimesproducehighinflationandsolvingproblemsisthekeytocontrollinginflationKydlandandPrescottwontheNobelPrizein2004oThePuzzleofHighInflationIfinflationishighthecentralbankcanreduceitbytighteningpolicybutthisactionreducesoutputintheshortrunSometimespolicymakersareunwillingtopaythispriceThisreasoningrestsontheassumptionofadaptiveexpectationsWiththatassumptionwecanwritethePhillipscurveequationaspp1aInflationequalspastinflationiftheoutputgapiszerotoreduceinflationthecentralbankmustpushoutputbelowpotentialFigure161InitiallyexpectedinflationishighbutthecentralbankidealannouncesitwillreduceinflationtopExpectationsarerationalandthepublicbelievestheannouncementsoexpectedinflationfallsThePhillipscurveshiftsdownallowingthecentralbanktoreduceinflationwithoutreducingoutputoAnsweringthePuzzleidealFigure162IfexpectedinflationequalspthecentralbankchoosesbetweentwooutcomesfortheeconomyshownherebythepointslabeledAandBonthePhillipscurveIntheKydlandPrescotttheorypolicymakersarelikelytochooseoutcomeBwhichimpliesidealthatapromiseofppisnottimeconsistentFigure163Whenthepublicunderstandsthecentralbanksincentivesbothexpectedandactualinflationarehigh
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