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Interest Rate Rules, Barro-Gordon Model

# Interest Rate Rules, Barro-Gordon Model

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12/16/2012

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# MACROECONOMICS: INTEREST

RATE RULES, BARRO-GORDON
MODEL
INTEREST RATE RULES
An interest rate rule gives a direct relationship
between the primary tool of a Central Bank (the
interest rate) and inflation and output.
It is essentially the maths behind the three-
equation model developed previously.
We shall therefore be using the following
equations:
IS: y
t
² y
e
= -a(r
t
² r
s
)
IAPC: Ǒ
t
= Ǒ
t-1
+ ǂ(y
t
² y
e
)
MR: Ǒ
t
² Ǒ
T
= -(1/ǂǃ)(y
t
² y
e
)
INTEREST RATE RULES
Substitute the IAPC into the MR;
Ǒ
t-1
+ ǂ(y
t
² y
e
) ² Ǒ
T
= -(1/ǂǃ)(y
t
² y
e
)
(y
t
² y
e
) = -a (r
t
² r
s
) (The IS equation), so subbing
in:
Ǒ
t-1
-aǂ(r
t
² r
s
) ² Ǒ
T
= (a/ǂǃ)(r
t
² r
s
)
Ǒ
t-1
- Ǒ
T
= (aǂ + a/ǂǃ)(r
t
² r
s
)
Thus, the above equation can be arranged to
arrive at:
INTEREST RATE RULES
Here:
The bottom equation holds if all parameters are 1.
The important point here is that ALL the parameters
are included in the consideration of interest rate
changes.
A problem, however, is that only INFLATION is
considered, when output is also in the loss function.
´ )
´ )
T
t s t
T
t s t
r r
a
r r
z z

o
z z
=
¦
¦
¦
¦
¦
'
+

'

¦
¦
'
+

'

+
=

1
1
5 . 0
1
1
THE DOUBLE LAG
In order to include output considerations, we
must realise that there are lags in the economy.
Interest rates take 1 period to affect output and
output takes a further period to affect inflation:
We can thus use this knowledge and update the
time indicators on the 3-equation model we used
previously.
Ǒ
t-1
Ǒ
t
Ǒ
t+1
y
t
y
t-1
r
t-1
THE TAYLOR RULE
IS: y
t
² y
e
= -a(r
t-1
² r
s
)
IAPC: Ǒ
t
= Ǒ
t-1
+ ǂ(y
t-1
² y
e
)
MR: Ǒ
t+1
² Ǒ
T
= -(1/ǂǃ)(y
t
² y
e
)
Follow the same steps as last time, but at the
end, sub in inflation to get the output expression:
THE TAYLOR RULE DERIVATION
´ )
´ )
´ ) ´ )
´ ) ´ ) ´ ) ´ )
e t t s t
s t e t t
e t t
e t e t t
y y
a
r r
r r a y y
y y
y y y y

¼
½
»
¬
­
«
¦
¦
'
+

'

!

¼
½
»
¬
­
«
¦
¦
'
+

'

!

¼
½
»
¬
­
«
!

¼
½
»
¬
­
«
!

1 1 1
1 1 1
1
1
1
1
1
) (
E T T
EF
E
EF
E T E T
EF
E T T
EF
T E T
THE BARRO-GORDON MODEL
The Barro-Gordon Model (BGM) is concerned
with what happens when the targeted level of
output ¶y· is GREATER than y
e
.
Next slide derives it diagrammatically and it is
derived mathematically following that.
Assume, however, that there is a Lucas ¶surprise·
supply function and a loss function of the form:
L = (y ² ky
e
)
2
+ (ʋ
t
ʹ ʋ
T
)
2
Where ¶k· is a positive constant greater than one.
IMPORTANT: RESULT HOLDS FOR
IAPC/EAPC AS WELL, BUT IT TAKES TIME.
THE BARRO-GORDON MODEL
The Diagram to the right shows the
effects of setting an output target
greater than the natural rate of
output.
Initially we are at A with inflation
Ǒ
T
and output y
e
.
However, the Government may
cheat and decide to try and
boost output to ky
e
(i.e, move to
point B).
However, because they are
constrained to the SRAS curve, they
will choose the optimal point along
it (C) as it is tangential to their
preference circles.
This leads to a higher inflation rate
Ǒ
1
which shifts the SRAS curve up
next period.
The economy will then move to
point D. This continues until
point E, a point on the LRAS
curve.
Hence, output ends up at y
e
and
inflation is higher than targeted.
Ǒ
B
² Ǒ
T
is the INFLATION BIAS.
Ǒ
Y ky
e
y
e
Ǒ
T
A B
C
D
E
LRAS
SRAS (Ǒ
T
)
SRAS (Ǒ
1
)
SRAS (Ǒ
B
)
Ǒ
1
Ǒ
2
Ǒ
B
BARRO GORDON MATHS:
´ ) ´ )
´ )
´ ) ´ ) ´ )
´ ) ´ ) ´ )
´ ) ´ )
´ )
2
2
2 2
2
2
2
2
1
1 2 2
2 2 2 1 2 2 .
0 2 2
: Substitute
: to Subject
: Function Loss
.
. z z .
z
. z z . . z
z z z z . .
z
z z z z .
z z .
z z
+
+ +
=
+ = +
= + + =
¯
¯
+ + =
+ =
+ =
k y
y k y
y k y
V
y k y V
y y
y k y V
T e
T e
T e
T e
e
T
BARRO-GORDON MATHS
That equation describes the reaction function
(the grey line in the previous diagram). In order
to find what rate will be selected, we must TAKE
EXPECTATIONS.
The size of the inflation bias, therefore, is (k-
1)ɽY
e
We can put this value back into the reaction
function equation to see what point the Gov. Will
choose.
If we do this, we get the SAME level of inflation.
´ )
´ ) y k
y k
E
T B e
e T
e
. z z z
.
. z . z
z z
1
1
1
2
2
+ = =
+
+ +
= =
LASH IT TO THE MAST!
The problem with the Government being in charge of policy
is therefore evident, should we consider game theory.
We can think of this as a finite game, with the end known
(elections). Thus, the game will ¶unravel· such that the
Government will ¶cheat· straight away.
Hence the Central Bank ² no elections, therefore it is an
infinite game and there is no incentive to cheat.
The Central Bank itself must build credibility over
time; one possible way to do this is to tie itself to a
reputable central bank (Europe did this with the
Bündersbank).
Another way of establishing credibility is for ¶Walsh
Contracts·. That is, a set of incentives provided by the
Government for the Central Bank to reach the targeted
inflation level (New Zealand).
There may be little incentive to cheat anyway in developed
capital markets ² although there are lags between the
stimulus and economic activity, there are NO lags between
the stimulus and capital flight that will follow, should
investors decide the stimulus signals a weakness in the
currency.

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