QUESTION NO.

O1(A)

Understanding Unemployment and Inflation: The Basics

Before we delve into the scenarios, it's essential to clarify a couple of key
economic concepts:

 Unemployment Rate (u): This is the percentage of the labor force that is
jobless and actively looking for work.
 *Natural Rate of Unemployment (u)*: This is the unemployment rate when
the economy is healthy and there's no short-term boosting or slowing down
from economic policies. It includes frictional unemployment (people
between jobs) and structural unemployment (when jobs exist but don't match
the workers' skills).
 Inflation (π): This is the rate at which the general level of prices for goods
and services is rising, and subsequently, purchasing power is falling.
 Expected Inflation (Eπ): This is what people predict inflation will be in the
future. It matters because it affects how people make decisions about
spending, saving, and wage demands.
The Phillips Curve
The Phillips Curve is a concept in economics that shows an inverse relationship
between the rate of unemployment and the rate of inflation. This means that
sometimes, if inflation is higher, unemployment might be lower, and vice versa.

Scenario Analysis

(i) Inflation is always zero:

 What Happens?: If inflation is always at 0%, it means that the prices of
goods and services aren't going up.
  Expectations: People also expect inflation to stay at 0%, so they don't
demand higher wages to keep up with rising prices (because there are none).
 Unemployment Rate: Without inflation pushing prices up or down, the
unemployment rate stays at the natural rate. This is like a balanced state
where the number of people who want jobs is about the same as the number
of jobs available.
(ii) Inflation is a constant five percent:
 What Happens?: Now imagine that prices do go up, by 5% every year.
 Expectations: People see this happening and start to expect that 5%
inflation is just how things are going to be.
 Wage Adjustments: Because everyone expects prices to be 5% higher, they
just adjust everything, like wages and contracts, for this 5%. A new balance
is found at this 5% inflation rate.
 Unemployment Rate: With everyone expecting and adjusting for 5%
inflation, unemployment doesn't go up or down because of inflation. It stays
at the natural rate, just like in the first scenario.
What Does It All Mean?
In both scenarios, the unemployment rate doesn't change because of inflation in the
long term. If inflation is zero or constant and expected, people and companies
adjust, and there's no surprise to push unemployment away from its natural rate.

However, if inflation is different from what everyone expected (like if people

expected 3% but got 5%), there could be some short-term effects. For example, if
inflation is higher than expected, companies might be able to sell their goods for
higher prices without paying their workers more, so they might hire more workers
and unemployment could go down for a little while.
Key Takeaway
The natural rate of unemployment is like the default setting for the economy's
unemployment level. It's where things tend to settle unless there's some surprise or
big change that hasn't been planned for.

QUESTION NO. O1(B)

Understanding Random Inflation and Its Impact on Unemployment

We're going to talk about what happens when inflation isn't steady and how it
affects jobs. Imagine inflation as the rate at which prices of things we buy go up
over time, and unemployment as the number of people who can work but can't find
jobs.

Part (i) - Expected Inflation

 Expected Inflation: When we talk about "expected inflation," we're
referring to the inflation rate that people think will happen in the future. It's
like a prediction or a guess based on what's been happening with prices.
 Calculating Expected Inflation: If inflation can be anywhere between 0%
and 10%, we take the middle point as the expected inflation. So, if it's like
flipping a coin where heads is 0% and tails is 10%, we expect to land in the
middle, which is 5%.
Part (ii) - The Observed Phillips Curve
 Phillips Curve: This is a line we draw on a graph to show the relationship
between inflation and unemployment. Usually, we think that if inflation goes
up a little, unemployment goes down because companies make more money
and can hire more people.
  Random Inflation: Now, if inflation is like rolling a die and can land on
any number between 0 and 10, it's unpredictable. We don't know if it will be
high or low, so people can't guess correctly all the time.
 Impact on Jobs: When inflation is not what we expected, it can surprise
companies and workers. If inflation is less than 5%, companies' costs are
higher than they thought, and they might not hire as much, leading to more
unemployment. If it's more than 5%, things cost less than expected, so they
might hire more, and unemployment goes down.
 The Graph: The graph you see (attached with the question) isn't a smooth
curve but a bunch of dots spread out. The red line shows the natural
unemployment rate where we'd be if inflation was always as expected. The
dots below the line are times when inflation was higher than 5%, and the
dots above are when it was lower.
Key Takeaway
When inflation is unpredictable, it's like the weather changing a lot. Some days it's
hotter or colder than you expected, so you might wear the wrong coat. Just like
that, when inflation isn't what we expected, companies and workers might make
the wrong choices, leading to more or fewer jobs than the "normal" amount. Over
time, though, people get better at predicting the "weather" of inflation, and things
stabilize back at the natural rate of unemployment, which is shown by the red line.

QUESTION NO. O1(C)

Notes on Random Inflation and the Phillips Curve
When we look at how the economy works, two things we often hear about are
inflation and unemployment. Here's how they relate to each other and what
happens when inflation doesn't stick to a pattern.

Understanding the Terms

 Inflation Rate (x-axis): This is like a speedometer for prices. It tells us how
fast the prices of things you buy, like food and clothes, are going up. If the
inflation rate is high, prices are rising quickly.
 Unemployment Rate (y-axis): Think of this as a measure of how many
people are looking for a job but can't find one. A high unemployment rate
means a lot of people are out of work.
 Natural Rate of Unemployment: This is the level of unemployment that we
expect in a healthy economy when there isn't too much or too little inflation.
The Graph and Its Meaning
 Blue Dots: Each dot shows what was happening at a certain time. It tells us
the inflation rate and how many people were out of work at that moment.
 Red Line: This is the "normal" unemployment rate we'd see if everything
was stable and there were no surprises in how fast prices were rising.
How to Read the Graph
 Above the Red Line: When blue dots are above the red line, it means more
people were out of work than we'd expect. This could happen when prices
aren't rising as fast as everyone thought they would.
 Below the Red Line: When blue dots are below the red line, it means fewer
people were out of work than normal. This might happen when prices rise
faster than everyone expected.
The Big Picture
 Short-Term vs. Long-Term: In the short term, things can be a bit all over
the place, like our blue dots. But over time, as people get better at predicting
inflation, the unemployment rate starts to hover around the red line more
consistently.
 Vertical Long-Run Phillips Curve: After a while, no matter what inflation
does, unemployment tends to settle at the natural rate (our red line). This
means that in the long run, inflation doesn't have a lasting effect on
unemployment.
Key Takeaway
The relationship between inflation and unemployment can be unpredictable.
Sometimes, when prices rise or fall unexpectedly, it can affect jobs. But as people
and businesses get used to these changes and start to expect them, the job market
stabilizes, and unemployment returns to what's normal for a healthy economy.

QUESTION NO. O1(D)

Detailed Notes on Inflation, Unemployment, and

Policymaking
Imagine you're at a restaurant, but instead of food, you're choosing between
different levels of inflation (prices going up) and unemployment (people without
jobs). Policymakers at the "economy restaurant" are trying to pick the best
combination for the country.
Understanding the Menu
 Inflation-Unemployment Menu: This is like a list of choices that
policymakers have. They can't pick just any combination; they're limited by
what's actually possible in the economy.
 Phillips Curve: It's like a guide to the menu. It shows the trade-off between
inflation and unemployment. Normally, if you pick more inflation, you get
less unemployment, and vice versa.
The Actual Choices
 Expected Inflation (E(π)): If inflation rates can be anywhere between 5%
and 15%, we expect it to average out to 10%. This is like guessing the
middle number on a spinning wheel that stops randomly between 5 and 15.
 Short Run: Right after the policymakers make their pick, it seems like they
can have low unemployment by letting inflation be a bit higher. But this is
only for a little while.
 Long Run: Eventually, the economy catches on to this game. Workers ask
for higher wages because they expect prices to go up, and the benefit of
lower unemployment disappears. We end up back where we started with the
natural rate of unemployment, no matter what inflation is.
What Policymakers Might Mistakenly Believe
 Misconception: Some policymakers might think they can keep
unemployment low all the time by just allowing more inflation. This is like
thinking you can eat cake every day and not expect any consequences.
 Reality Check: Just like you can't cheat a diet, policymakers can't cheat the
economy. People adjust to the higher prices, and the advantage of low
unemployment vanishes. This results in a long-run situation where inflation
doesn't help reduce unemployment.
Summary
 Long-Run Reality: In the end, the only "meal" you can keep coming back
to is the one with the natural rate of unemployment, no matter how much
inflation you add to it. Everything else is like a special that's only good for
one day.
 The Illusion: Policymakers might think they have lots of choices, but the
real, sustainable options are more limited. Understanding this helps avoid
making decisions that feel good now but cause problems later.

QUESTION NO. 2(A)

Notes on Optimal Inflation Policy for Maximizing

Social Welfare
Key Concepts for Understanding the Scenario:
 Social Welfare (V): This is a measure of the overall well-being of society,
considering both how much stuff (goods and services) we're producing and
the negative effects of rising prices (inflation).
 Inflation Rate (π): This is how fast prices are rising. If inflation is high,
your money buys less than before.
 Natural Level of Output (ȳ): This is the amount of stuff produced when the
economy is healthy and not being artificially pushed by policies.
  Expected Inflation Rate (πe): This is what people think inflation will be in
the future. It's important because it influences business and consumer
decisions.
Finding the Best Inflation Rate:
 The Policymakers' Goal: They want to pick the best inflation rate (π) that
makes the country as well-off as possible.
 The Calculation: To figure this out, they use a bit of math that combines
how much stuff we're producing and the downsides of inflation. They adjust
the inflation rate (π) until they find the sweet spot where welfare (V) is the
highest.
The Optimal Inflation Rate:
 Math in Action: After some calculations (using differentiation, which is a
way to find high and low points in math), they find the best inflation rate to
be π=β/ α
 What This Means: This rate balances making more stuff with the costs of
rising prices. But here's the catch: this only works if people's predictions
about inflation are exactly right.
Rational Expectations:
 Smart People in the Economy: Everyone else is also doing math and
predicting that the policymakers will choose π=β/ α for inflation.
 What Happens Next: Because everyone expects this inflation rate, there are
no surprises, and the amount of stuff produced (output) is just right (at the
natural level, ȳ).
Impact on Social Welfare:
 Final Outcome: With the output at its natural level and everyone expecting
the chosen inflation rate, the economy is at its best given the circumstances.
 The welfare loss is minimal because it's only due to the chosen inflation rate,
and there's no surprise inflation to throw things off.

Simplified Explanation
Imagine the economy is a car, and the policymakers are trying to drive at the best
speed. They have to consider the fuel (inflation) they're using. If they use too
much, it might hurt the car (the economy), but if they use too little, the car won't go
fast enough (low output). They use a special formula to find the perfect balance,
which is the best speed (optimal inflation rate). But everyone in the car has to
agree on the speed for it to work smoothly.

What we find is that when the policymakers choose the right speed and everyone
in the car agrees with it, the ride is smooth, and the car goes just fast enough to get
to the destination on time without any trouble. This makes for the best trip
(maximized social welfare) possible, considering the car's condition and the road
ahead.

QUESTION NO. 2(B)

Detailed Notes on Zero-Inflation Policy and Its Effects
The Basics
First, let's get to grips with some essential terms and what they mean in simple
language:

 Federal Reserve (Fed): Think of the Fed as the teacher of a large classroom
(the economy), trying to keep everything orderly and running smoothly.
 Inflation (π): This is how quickly prices for things like snacks and video
games are going up. Zero inflation means the price of your favorite
chocolate bar won't change.
 Expected Inflation Rate (πe): This is what people in the classroom expect
to happen with prices in the future. If they trust the teacher, they'll believe
prices will stay the same when she says so.
 Output (y): This is like the total amount of homework and classwork
everyone in the classroom can do. It's best when everyone is working at a
steady, comfortable pace.
What the Fed is Doing
 Zero-Inflation Policy: The Fed is promising not to let prices start climbing
(like keeping the cost of lunch tickets steady).
 Public Belief: Everyone in the classroom trusts the Fed to keep this promise.
Calculating the Outcome
 Inflation Rates: Both the expected and actual inflation rates are zero
because the Fed promised, and everyone believes it (no one is expecting any
surprise quizzes).
 Output Level: Because there's no surprise from changing prices, everyone
can focus on their work, and the classroom runs at its natural pace.
The Fed's Goal (Objective Function, V)
 What's V?: V is like the happiness score for the classroom. It's highest
when everyone is working comfortably, and there are no nasty price
surprises.
 Calculating V: Since the Fed has kept its promise, and no one is worried
about prices going up, the happiness score is at its best.
The Perfect Scenario
 The Classroom: Just like the Fed's classroom, when there's no inflation
(prices stay the same), and everyone trusts that, things go as well as they
can. Everyone's happy because there are no sudden price hikes to deal with,
and they can get on with their work.

Key Takeaways
 When the Fed says it won't let prices rise and keeps that promise, it's like a
teacher ensuring a calm and predictable classroom where everyone can do
their best.
 Trust is key. When the teacher makes a promise, and the class believes it,
everyone works together smoothly.
 With zero inflation and trust in that stability, the economy (or classroom)
can focus on doing what it does best without worrying about the distraction
of rising costs.
This explanation aims to use relatable scenarios to explain how a zero-inflation
policy can lead to the best possible outcome in terms of social welfare and
economic stability, assuming everyone believes in and adheres to the policy.
QUESTION NO. 2(C)

Notes on the Time-Inconsistency Problem in Monetary

Policy
What is the Time-Inconsistency Problem?
The time-inconsistency problem is like a temptation to break a promise for
immediate gain. Imagine a diet plan promising no dessert to lose weight, but once
you start losing weight, you think a little dessert won't hurt. Similarly, the Federal
Reserve (the Fed) might promise no inflation to keep the economy stable but later
be tempted to allow some inflation to boost the economy temporarily.

The Fed's Promise and Temptation

 Zero-Inflation Policy: The Fed is like a teacher who promises no surprise
quizzes (zero inflation) so students (the public) can plan their study time
(financial decisions) effectively.
 Incentive to Deviate: After the students get used to no surprises, the teacher
might think a pop quiz (some inflation) will make the class more exciting
(boost the economy) for a while.
Calculating the New Scenario
 Optimal Discretionary Rate: This is when the Fed decides to use a little
inflation, πt=β/ α to make things more exciting.
 Output (y_t): With this new rate, the class gets more work done than usual
because of the unexpected quiz. The amount of work (output) goes up
temporarily.
 yt =yˉ +β2/ α
 Value of Policymakers' Objective Function (V): This is like the happiness
score for the classroom. With the surprise quiz, the happiness goes up
because there's more work done, but it's only for a short time.
V=yˉ + β2/2α
Comparing the Outcomes
 Before (Parts A and B): The happiness score was at its best when everyone
expected what was coming, whether it was no quizzes or just the right
amount of quizzes.
 After (Part C): The score is even higher with the surprise quiz because it's
exciting and different, but it's not something that can be done every day
without losing its effect.
The Long-Term View
 Sustainability: Just like surprise quizzes can't be given every day, inflation
can't keep boosting the economy. People catch on, and the excitement
(economic boost) wears off.
 Credibility: If the teacher keeps giving surprise quizzes after promising not
to, students will stop believing her. Similarly, if the Fed breaks its promise
on inflation, people will lose trust, and they'll start expecting more inflation,
which could lead to a less stable economy.

Simplified Explanation
It's like when you're playing a game, and you have a strategy that you tell everyone
you'll stick to, but halfway through, you change it for a quick advantage. It might
work once, but if you keep doing it, others will catch on, and it won't work
anymore. They might even start playing differently because they don't trust you,
which changes the game entirely.

The Fed faces a similar issue with inflation. It can say no inflation to keep things
steady, but then be tempted to change that for a quick benefit. This might help at
first, but over time it can lead to problems like people expecting higher prices all
the time, which isn't good for anyone in the long run.

This explanation aims to demystify the concept of time-inconsistency using

everyday scenarios, making the topic accessible for a student with no background
in economics.

QUESTION NO. 2(D)

Detailed Notes on Overcoming the Time-Inconsistency

Problem
The Challenge of Sticking to Promises in Economic Policy
 Time-Inconsistency Problem: This is like when you promise yourself
you'll eat healthy, but when you see a delicious cake, you're tempted to eat
it. The Federal Reserve (Fed) faces a similar issue: it promises no inflation
but might be tempted later to allow some to boost the economy.
The Conservative Central Banker Solution
 Conservative Central Banker: Think of this banker as someone who really,
really doesn't like inflation. It's like a health coach who hates junk food;
they're going to make sure you stick to your healthy eating promise because
they believe it's very important.
Why the Conservative Approach Works
 High Cost of Inflation: The conservative banker sees inflation as very
costly, like a health coach sees junk food as very unhealthy. This means
they'll do everything to avoid inflation, ensuring prices stay stable.
 Aligning Policy with Promises: Because the conservative banker dislikes
inflation so much, they'll stick to the zero-inflation policy, which makes the
promise credible.
Calculating the Banker's Decision
 Objective Function (Vc): This is a formula the banker uses to decide what
to do. It's like a rule a health coach uses to plan your diet.
 Vc =yt −(αc/2)* π2t
 Output (y_t): This is the amount of stuff the economy produces. When
there's no inflation, the output is just right—like eating the right amount of
food.
 Setting the Inflation Rate (π_t): Because the cost of inflation is so high in
the banker's eyes, they decide to keep it at zero. This means no change in
prices, and the economy is at its best.
The Outcome
 Natural Level of Output: With zero inflation, everything runs smoothly,
and we get the right amount of stuff produced—no more, no less.
 Maximizing Welfare: With the conservative banker in charge, the
economy's "happiness score" is as good as it can be because there's no
inflation messing things up.
Simplified Explanation
Imagine you're playing a game where you need to keep your points stable to win.
You promise not to take any risky moves that could change your points too much.
But sometimes, you might be tempted to take a risk to get more points quickly. To
make sure you stick to your promise, you bring in a friend who is really good at
playing it safe. Your friend helps you avoid risks, so your points stay stable, and
you end up winning the game.

In the real world of money, the Fed is playing a game where it promises to keep
prices stable (zero inflation). But it might be tempted to change prices a bit to
boost the economy. To avoid this, they bring in a conservative central banker who
really wants to keep prices stable. This banker helps the Fed stick to its promise,
which is good for everyone in the long run.