ECC230: Week 7 Central banks Time inconsistency problem

What is the time inconsistency problem in monetary policy?

It refers to the tendency of policymakers to renege on promises due to changing incentives, leading to suboptimal outcomes.

Who won the Nobel Prize in 2004 for their work on time inconsistency?

Finn E. Kydland and Edward C. Prescott.

What was the purpose of the Bank of England when it was founded in 1694?

To purchase government debt and lend money to fund wars.

What is the world's oldest central bank?

Sveriges Riksbank (Riksens Ständers Bank) in Sweden.

What are the main roles of early central banks?

To lend the government funds and act as a clearing house for commerce.

What is the significance of the 1844 Bank Charter Act?

It prohibited new banks from printing their own notes.

What does LOLR stand for in the context of central banking?

Lender of Last Resort.

What are the implications of central bank independence?

It allows for more credible and stable monetary policy free from political influence.

What is inflation bias?

It refers to the tendency of policymakers to create higher inflation than intended due to time inconsistency.

What did Kydland and Prescott's 1977 paper discuss?

The inconsistency of optimal plans in monetary policy and the importance of rules over discretion.

What historical problem did central banks aim to solve?

The issues arising from multiple institutions printing their own banknotes and the need for a unified currency.

How did paper money solve the coincidence of wants problem?

It allowed for a medium of exchange that didn't require a direct trade of goods.

What was the initial interest rate on the £1,200,000 loan to the Bank of England?

8%.

What is the Barro-Gordon model?

A model that explains the trade-off between inflation and unemployment under rational expectations.

What is the role of central banks in relation to commercial banks?

They serve as a bank for bankers, facilitating transactions and providing banking services.

What was John Law's contribution to central banking?

He suggested the idea of a central bank to control the money supply and stimulate the economy.

What does the term 'central bank credibility' refer to?

The trust in a central bank's ability to maintain stable monetary policy and control inflation.

What was the impact of the 1998 Bank of England Act?

It granted the Bank of England operational independence.

What is the significance of the Kydland-Prescott model?

It illustrates how time inconsistency can lead to suboptimal policy outcomes.

What does the term 'promissory notes' refer to in the context of early banking?

Documents promising to pay a certain amount of money, which evolved into early forms of paper money.

What is the relationship between central banks and fiscal policy?

Central banks control the money supply and have links to fiscal policy, influencing economic stability.

What is the main focus of the lectures in weeks 7 and 8?

The roles of central banks and the importance of their independence in monetary policy.

What historical event led to the establishment of the Bank of England?

The need to finance wars with France.

What is the relationship between central banks and trust in currency?

Government backing of central banks increases trust in the redeemability of their money.

What are the advantages of a unified paper currency?

It simplifies transactions and enhances trust in the monetary system.

What does the term 'bank runs' refer to?

A situation where a large number of customers withdraw their deposits simultaneously due to fears of a bank's insolvency.

What is the purpose of central banks in alleviating bank runs?

They act as a lender of last resort to provide liquidity to banks in distress.

What did Kydland and Prescott's results explain?

They provided a common explanation for separate policy failures, showing how economies can become trapped in high inflation despite the objective of price stability.

What key concept did Barro and Gordon emphasize in their model?

The formation of expectations is crucial to the model's outcomes.

What is the difference between discretion and commitment in policymaking?

Discretion allows policymakers to act without constraints, while commitment involves adhering to a predetermined rule or mandate.

What is the loss function in the Barro-Gordon model?

It is represented as L = (U_t - U)^2 + a(π_t - π)^2, where U is the unemployment target and π is the inflation target.

What does the inverted Phillips curve indicate?

If actual inflation exceeds expectations, unemployment will be lower than the natural rate.

What is the primary interest of the Barro-Gordon model?

To analyze the outcomes of monetary policy under rational expectations.

What happens under discretion in the Barro-Gordon model?

The policymaker acts in their own best short-term interest, often leading to suboptimal outcomes.

What is the role of expectations in the Barro-Gordon model?

Expectations influence the effectiveness of monetary policy and the resulting economic outcomes.

What does the Barro-Gordon model suggest about government preferences?

The government prefers unemployment to be lower than the natural rate to avoid losing votes and to respond to union pressures.

What are the types of expectations discussed in the Barro-Gordon model?

Naïve, anchored, rational, and adaptive expectations.

What is the significance of the quadratic loss function in the Barro-Gordon model?

It implies that deviations from targets for inflation and unemployment are equally undesirable.

What does the term 'naïve expectations' refer to?

Public beliefs that inflation will be what the government promises.

How does the Barro-Gordon model treat the policymaker?

The policymaker is assumed to be the government, not an independent central bank.

What is the outcome if the government can commit to a rule?

Outcomes differ positively compared to discretion, leading to more stable economic conditions.

What is the relationship between inflation expectations and the Phillips curve?

The Phillips curve relates actual inflation to expected inflation and unemployment.

What is the government's bliss point in the loss function?

It is the point where the government's loss is minimized, balancing inflation and unemployment targets.

What does the Barro-Gordon model imply about the government's incentive to cheat?

If the public believes the government will set policy to achieve a target, the government may have an incentive to deviate from that promise for short-term gains.

What is the significance of the timing in the Barro-Gordon model?

It outlines the sequence of actions between public expectations and policymaker decisions regarding inflation.

What is the effect of actual inflation exceeding expectations?

It results in lower unemployment than the natural rate due to increased labor demand.

What does the Barro-Gordon model suggest about the political feasibility of economic policy?

It highlights the importance of credibility and institutional design in effective monetary policy.

What is the implication of the Barro-Gordon model for central bank reforms?

It has influenced reforms towards more independent and accountable central banks in various countries.

What does the term 'commitment to a rule' mean in the context of monetary policy?

It refers to the ability of a policymaker to credibly adhere to a predetermined policy framework.

How does the Barro-Gordon model address repeated games in policymaking?

It considers how reputation and long-term policy choices affect decision-making over time.

What is the expected outcome of a policymaker acting under discretion?

They may prioritize short-term gains over long-term stability, potentially leading to higher inflation.

What is the role of the Phillips curve in the Barro-Gordon model?

It describes the trade-off between inflation and unemployment in the context of monetary policy.

What is the Barro-Gordon model primarily concerned with?

The relationship between inflation and unemployment, particularly in the context of government policy.

What does the 'naïve' solution in the Barro-Gordon model imply?

It suggests that policymakers will renege on their promises regarding inflation once expectations are set.

What is unachievable if the policymaker has discretion?

The promised inflation rate (t*) is unachievable.

What does the Phillips curve imply about inflation and unemployment?

It indicates that a lower unemployment rate (U*) can only be achieved at the cost of higher inflation.

What is the implication of the government choosing πt = π*?

It results in U_t being greater than U (U_t > U).

What does the loss function in the Barro-Gordon model represent?

It quantifies the trade-off between inflation and unemployment that the government faces.

What is the outcome when the government chooses U_t = π*?

It leads to π_t being greater than π (π_t > π).

What is the 'time inconsistent solution' in the Barro-Gordon model?

It refers to the situation where the policymaker's initial promise of an inflation rate is not kept, leading to a mismatch between expectations and reality.

What must happen for the naïve equilibrium to be sustained?

The public must continually be fooled into believing that the government will keep its inflation promise.

What is the role of rational expectations in the Barro-Gordon model?

Rational expectations assume that the public uses all available information to form expectations about future inflation.

What happens when the public adjusts their expectations in response to government actions?

It leads to higher inflation and unemployment than both the optimal choice and the naïve solution.

What does the term 'surprise inflation' refer to in the context of the Barro-Gordon model?

It refers to inflation that is higher than expected, which the government may generate to reduce unemployment.

What is the significance of the isoloss curves in the Barro-Gordon model?

They indicate the trade-offs between inflation and unemployment that minimize the government's loss.

What does the government need to select to achieve welfare maximization?

The government would need to choose an inflation rate (π_A) that results in higher unemployment (U_A) than the natural rate (U*).

What is the expected inflation rate when the public believes the government will keep its promise?

The expected inflation rate (π_t^e) is set equal to the promised rate (π*).

What does the discretionary solution under rational expectations entail?

It involves the policymaker choosing inflation to minimize loss while considering the public's expectations.

What is the relationship between the natural rate of unemployment (U_N) and the optimal unemployment rate (U*)?

The government desires unemployment (U_N) to be below the natural rate (U_N < U*).

What is the implication of the government being constrained by the Phillips curve?

It limits the government's ability to achieve both low inflation and low unemployment simultaneously.

What does the equation π_t = π_t^e - (1/b)(U_t - U_N) represent?

It describes the relationship between current inflation, expected inflation, and the unemployment gap.

What is the significance of the statement 'You can fool all the people some of the time...' in the context of the Barro-Gordon model?

It highlights the limitation of government deception in maintaining low inflation expectations over time.

What does the term 'time-consistent equilibrium' refer to?

It describes a situation where the policymaker's actions align with their promises, maintaining credibility.

What happens if the public cannot be fooled repeatedly?

The government will face higher inflation and unemployment due to rational adjustments in public expectations.

What does the loss function in the Barro-Gordon model aim to minimize?

It aims to minimize the trade-off between inflation and unemployment.

What is the expected outcome if the government chooses π_t = π_B?

It results in higher inflation than the target inflation rate (π*).

What does the term 'bliss point' refer to in the context of isoloss curves?

The bliss point represents the ideal combination of inflation and unemployment with no loss.

What is the effect of the government choosing U_N and π*?

It is not a rational choice as it does not maximize welfare given the constraints of the economy.

What is the time-consistent inflation rate?

The time-consistent inflation rate is the rate that is above the target inflation rate.

What is the implication of a time-consistent inflation rate above target?

It implies a strictly positive welfare loss.

How does unemployment relate to inflation in a time-consistent equilibrium?

Despite inflation being above target, there is no compensating gain in lower unemployment.

What does it mean when inflation expectations equal actual inflation?

It means the economy is always at the natural rate of unemployment.

What is the optimal unemployment rate in a rational expectations equilibrium?

The optimal unemployment rate is the natural rate of unemployment.

What is inflation bias in the time-consistent equilibrium?

It is a positive inflation bias that arises due to the time inconsistency problem.

What are anchored expectations?

Expectations that are relatively insensitive to incoming data and consistent with central bank targets.

How do naïve expectations differ from anchored expectations?

Naïve expectations are unchanging, while anchored expectations can vary based on economic developments.

What does Ben Bernanke say about anchored expectations?

He states that they are not perfectly anchored and can change depending on monetary policy conduct.

What is the effect of imperfectly anchored expectations on the Phillips curve?

The Phillips curve would shift in response to new information causing changes in inflation expectations.

What is the relationship between anchored expectations and stabilization policy?

Anchored expectations reduce the cost of stabilization policy, allowing for more effective monetary and fiscal responses.

What happens to the Phillips curve during an inflation shock with non-anchored expectations?

The Phillips curve shifts upwards by the amount of the shock.

What is the outcome when expectations are perfectly anchored during an inflation shock?

The Phillips curve remains stable, and unemployment does not need to rise to bring inflation back down.

How does the extent of anchoring affect unemployment during inflation shocks?

The more anchored the expectations, the lower the rise in unemployment required to counteract inflation.

What is the conclusion regarding disinflation policy when expectations are anchored?

Disinflation policy is less costly in terms of output loss and unemployment when expectations are anchored.

What does the Barro-Gordon model illustrate about equilibrium outcomes?

It shows how anchored expectations can lead to improved equilibrium outcomes in terms of inflation and unemployment.

What is the formula for inflation expectations in the rational expectations solution?

𝜋𝑡 = 𝜋𝑡𝑒 − (1/b)(𝑈𝑡 − 𝑈𝑁).

What does the term 'stabilization policy' refer to?

Monetary or fiscal policy aimed at counteracting shocks to stabilize the real economy.

What is the significance of the natural rate of unemployment in economic policy?

It serves as a target for policymakers aiming to achieve optimal economic stability.

What is the relationship between inflation expectations and the central bank's policy strategy?

Expectations are anchored when they align with the central bank's targets and policy strategy.

What is the impact of inflation expectations on the Phillips curve?

Changes in inflation expectations can lead to shifts in the Phillips curve, affecting unemployment and inflation rates.

What does the term 'welfare loss' refer to in the context of inflation?

Welfare loss refers to the economic cost incurred when inflation deviates from target levels.