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Ben J. Heijdra
1 September 2009
Outline
ED D
!
= (1/)[y ! y]
-
R
EC
LSCD
! C
ER E
! - !
y y* y
LSCR
= !(/)[y ! y*]
min L 1
2 [y y ]2 + 2 2 + [y y ( e ) ]
{,y}
y y = (/)
= (/) [y y ] (S1)
2 e + [y y ]
D = (S2)
2 +
We find:
[y y ]
C =
2 +
2
yC = y
+ y + 2
2 + 2 + +
t 1
2 [yt y ]2 + 2 2t
yt = y + [ t et ] , >0
R = 1
2 y y ]2
[
R ( R ) = R + 2 2R
Cheating solution
If the policy maker manages to make the agent expect that
the rule will be followed [ e = R ] then he has the incentive
to cheat by exploiting the Lucas supply curve associated with
e = R . The result is:
2 R + [y y]
C =
2 +
2
yC = 2
y
+ 2
y 2 R
+ + +
so that the objective function under cheating is:
2
1
C ( R ) = 2 [
yy ] 2 R
2 + +
2
2
+2 R + 2 [y y]
2 + +
Foundations of Modern Macroeconomics - Second Edition Chapter 9 16 / 34
Dynamic inconsistency and inflation
Voting and delegation
Taxation and consistency
Reputation (1)
We now introduce the following reputation mechanism
[tit-for-tat]:
R if t1 = et1
et =
D,t if t1 6= et1
If the policy maker did in the last period what the public
expected him to do ( t1 = et1 ) then this policy maker has
credibility and the public expects that the rule inflation rate
( R ) will be produced in the present period.
If the policy maker did not do in the last period what the public
expected him to do ( t1 6= et1 ) then this policy maker has
no credibility and the public expects that the discretionary
inflation rate ( D,t ) will be produced in the present period.
The public adopt the tit-for-tat strategy in the repeated
prisoners dilemma game that it plays with the policy maker. If
the policy maker misbehaves it gets punished by the public
for one period.
Foundations of Modern Macroeconomics - Second Edition Chapter 9 17 / 34
Dynamic inconsistency and inflation
Voting and delegation
Taxation and consistency
Reputation (2)
Consider a policy maker in period 0 which kept its promise and
produced the rule inflation in the period before [i.e. in period
-1 it set 1 = R ]. This policy maker has credibility in period
0 and the public expects e0 = R . The policy maker can do
two things in period 0:
Keep its promise and maintain its reputation [produce
0 = R ]. No punishment takes place!
Cheat in period 0 by producing C in that period [temptation
is present because R ( R ) > C ( R )]. But because he broke
his promise, the public punishes the policy maker and expect
the discretionary solution next period [ e1 = D ]. This involves
punishment because D > R ( R ) in period 1. In period 1
the public expects e1 = D and, given this expectation, it is
optimal for the policy maker to produce D . So policy maker
has reputation again in period 2 [as it kept its promise in
period 1] and the public expects e2 = R .
Foundations of Modern Macroeconomics - Second Edition Chapter 9 18 / 34
Dynamic inconsistency and inflation
Voting and delegation
Taxation and consistency
Reputation (3)
The benefits of cheating [temptation] are:
T ( R ) R ( R ) C ( R )
2
2
= [1
yy ] +
2 2
2
2 R y y] 2
[ 1
2 R
+ +
2
2
2 R + 2 [y y]
2 + +
The costs of cheating [punishment] are:
D R ( R )
P ( R )
1+r
2
1 + 2 1 2 2 1
= 2 [
y y ] 2 [ y y ] 2 R
1+r
2
1
= 12 y y ]2 2 2R
[
1+r
Foundations of Modern Macroeconomics - Second Edition Chapter 9 19 / 34
Dynamic inconsistency and inflation
Voting and delegation
Taxation and consistency
Reputation (4)
P, T
Enforceable region
E
!
EN P(BR)0
!
P(BR)1
T(BR)
T(BR)
!
B*R BD BR
Rogoff (1985) and Alesina & Grilli (1992) ask themselves why
central bankers tend to be conservative economists.
The median voter model of A & G can be used to cast some
light on this issue. Which agent is elected to head the central
bank?
Person i has the following cost function:
i 1
2 [y y ]2 + i 2
2 (S4)
y = y + [ e ] + , > 0
50%
$M $i
Technology:
F (Nt , Kt ) = aNt + bKt
C1 + [K2 K1 ] = bK1
C2 + G2 = F (N2 , K2 ) + K2 = aN2 + (1 + b)K2
Punchlines