ECON 100 Tutorial 21

1. ECON 100Tutorial 21 Rob Pryce www.robpryce.co.uk/teaching

2. Welcome back OFFICE HOUR FOR THIS FINAL TERM: WEDNESDAY 9:45 – 10:45 or by appointment FINAL CLASS TEST: May 17th EXAM: June 1st We have 4 or 5 more tutorials. Then you’re done!

3. Question 1 Explain the notion of the time consistency of economic policy An optimal policy computed at time t is time-inconsistent if a re-assessment at time t + n finds that a different policy is then optimal

4. Question 2 How is notion of a non-accelerating inflation rate of unemployment (NAIRU) relevant to the time consistency of economic policy? Gerry says: “By the adaptive expectations hypothesis, the long-run Phillips curve would have a positive slope (steeper than that of the short-run Phillips curve), because individuals expectations of the inflation rate would perpetually lag behind that of the actual inflation rate. Therefore, in perpetually ‘cheating’ on the inflation forecast, a monetary authority might engineer a lower rate of unemployment”

5. What is NAIRU? Non-Accelerating Inflation Rate of Unemployment Start with zero inflation 5% unemployment To reduce unemployment, government boosts AD, which lowers unemployment to 3% at the cost of 2% inflation Friedman and Phelps thought that workers would suffer from money illusion (ignore the inflation) in the short run. 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6

6. What is NAIRU? Non-Accelerating Inflation Rate of Unemployment But in the long run, because of the expectations-augmented Phillips curve, they adapt their expectations based on the 2% inflation they observe. Unemployment goes back to its previous level of 5%, but inflation stays at 2%. New Phillips curve upward and right of the old one. 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6

7. What is NAIRU? Non-Accelerating Inflation Rate of Unemployment Now if the government reduces unemployment to 3%, inflation must go up to 5.5% But again, in the long-run workers adapt their expectations and demand higher wages. This leads to greater unemployment – back to 5% – but inflation stays at 5.5%. And a new Phillips curve appears. Inflation is accelerating 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6

8. What is NAIRU? Non-Accelerating Inflation Rate of Unemployment The result is a long-run vertical Phillips curve. The green line is the long-run Phillips curve. The Non-Accelerating Inflation Rate of Unemployment is 5%. If you want more on this, watch this Youtube clip. 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6

9. Let’s go back to the question… How is notion of a non-accelerating inflation rate of unemployment (NAIRU) relevant to the time consistency of economic policy? Well, now we know that the NAIRU is based on the expectations-augmented Phillips curve. And workers’ expectations of inflation are updated constantly, based on what they observe. The central bank can achieve lower unemployment by “cheating” on their inflation forecasts. If the central bank tells people that the inflation rate is going to be 2%, and it’s actually 3%, then unemployment will be lower than it should be. I still think people have to be stupid to continue believing the central bank if it keeps doing this.

10. Question 3 Taylor rule: 3a) What is r*? the equilibrium interest rate 3b) Which data series are relevant? inflation rate (CPI), real GDP, Bank of England base rate 3c) Which data series have to be ‘constructed’? How? real potential GDP, from trends 3d) What are the units of measurement? percentages (eg. 0.02), y can be in whatever units (trillions, billions etc)

11. Question 3e r* = 2% π* = 2% w = 0.5 Inflation rate is 4.5% GDP is £1.33 trn Potential GDP is £1.4 trn r = 0.02 + 0.02 + 0.5 (0.045 – 0.02) + 0.5 ((1.33 – 1.4) / 1.4) r = 0.02 + 0.02 + 0.5 (0.025) + 0.5 (- 0.05) r = 0.02 + 0.02 + 0.0125 - 0.025 r = 0.0275 or 2.75%

12. Question 4 How is the Taylor Rule related to the loanable funds theory of interest rate determination and to the Phillips curve? Taylor rule and Loanable Funds With monetary equilibrium, the labour market clears at the natural rate of unemployment and the credit market clears at the natural rate of interest; and so in long-term equilibrium for the Expectations-augmented Phillips curve: πt = πexpected Loanable funds theory: rtmarket = rnatural

13. Question 4

14. Taylor Rule Question: What is the optimal base rate if there is no output gap and no inflation gap? r* + π* Question: What is w? the weight the central bank give to managing inflation over output must be between 0 and 1 Question: If the output gap is negative, what does Taylor advise the central bank to do? decrease the base rate, assuming everything else is constant

15. Quantitative Easing What is Quantitative Easing? The central bank creates new money Buys government bonds from financial institutions who hold the bonds These institutions now has spare money to invest And also reduces the government’s borrowing costs Long-term interest rates are lower More borrowing, more spending, boosts GDP Watch this clip (takes 56 seconds) from the BBC if you want to revise

16. Class Test and Exam Preparation There are past papers available online. A link is on the website. Use these as a guide! Discuss answers with friends, or Moodle discussion Moodle discussion works best when lots of people use it. Answering other people’s questions means you understand it, and helps you learn. If you want me to have a look at essay answers, feel free to email me. Answers can’t be longer than 2 pages (typed) or 3 pages (hand-written)

17. Any Questions? Email: r.pryce@lancaster.ac.uk Web: www.robpryce.co.uk/teaching OfficeHour: Wednesday, 9:45 – 10:45 Charles Carter C Floor or by appointment (email me)