EC2013 SEMESTER 2

TUTORIAL 4

EXPECTATIONS AND TIME INCONSISTENCY

Please prepare your answers in advance of the tutorial.

1. What role do expectations play in the IS curve that underpins the 3- equation model? Provide an example of a situation where a change in expectations of the future can influence households’ behaviour in the current period and shift the IS curve.

2. Describe the difference between risk and uncertainty. Provide an example of each case.

3. Explain what is meant by the following statement: "disinflation can be costless if the central bank is perfectly credible". Draw the impulse response functions for output, inflation and the real interest rate following an inflation shock and interpret your results, when:

(a) inflation expectations are fully backward looking

(b) inflation expectations are firmly anchored to the inflation target.

4. Assess the following statements S1 and S2. Are they both true, both false or is only one true? Justify your answer.

S1. Better communication by central banks can influence the path the economy takes after an economic shock

S2. Better communication by central banks does not affect how economic agents react to interest rate changes (which is the main tool used by monetary policy makers to achieve their inflation target). Hint: which of the curves IS-PC-MR is affected by communication?

5. Provide a definition of the Lucas critique. What is the relevance of the critique to the stagflation of the 1970s?

6. Imagine the government is able to exert control over monetary policy. What happens under adaptive expectations when the government targets a level of output above equilibrium? Is there a short-run trade-off between inflation and unemployment? How about under rational expectations?

7. Can a government with an overly ambitious output target credibly commit to targeting equilibrium output? If not, then how can they solve the inflation bias problem?

8. Is Keynes’ treatment of expectations consistent with the rational expectations hypothesis?

9. Assume that inflation expectations are formed rationally. Use the 3- equation model to show the adjustment of the economy to a permanent demand and a permanent supply shock. Provide a period by period explanation of the adjustment process.