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Interest Rate Rules, Barro-Gordon Model|Views: 553|Likes: 1

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12/16/2012

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**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

oß

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.

Final Final Dissertation

Growing up as a mixed race liberal Muslim in a post-9/11 Western society.

Development Essay Final

Natural Resource Curse

International Environmental Agreements

Externalities

Moral Hazard

Adverse Selection

Labour Income Taxation

Capital Income Taxation

Voluntary Agreements

Environmental Kuznets Curves

New Institutional Economics

Financial Development

Choice Under Uncertainty

Growth Theories

Aggregation Roys Identity

The Utility Maximisation Problem

Commodity Taxation

Dependency Theory

Environmental Taxation

Production

Imperfect Competition

Risk and Uncertainty

Intertemporal Choice, Time Allocation

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Economic Growth

Fiscal Policy

Real Business Cycle Theory

The Sargent & Wallace Policy Ineffectiveness Proposition, Lucas Critique

Political Business Cycles

The Open Economy (II); Purchasing Power Parity, Dornbusch Overshooting Model

IS LM, AD AS (closed economy)

The Open Economy (I); The Mundell-Fleming Model

The IS- LM Curve

Micro Economics

Mundell–Fleming model

MicroEconomics Study Notes

Micro Economics

Micro Economics

IS-LM

Macro Economics

Macro Economics

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