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÷ 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:

## ÷        

÷         

÷ m  
 ! "  



  
÷ Úubstitute the IAPC into the MR;
÷ Ǒt-1 + ǂ(yt ² ye) ² ǑT = -(1/ǂǃ)(yt ² ye)

## ÷ (yt ² ye) = -a (rt ² rs) (The IÚ equation), so subbing

in:
÷ Ǒt-1 -aǂ(rt ² rs) ² ǑT = (a/ǂǃ)(rt ² rs)

## ÷ Thus, the above equation can be arranged to

arrive at:
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  
÷ £ere:


è
      0   |

0



0
   

  
è
       0   |
÷ 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.

#    
÷ 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.

#
\$   
÷        
÷         

÷ m  
 ! "  

## ÷ Follow the same steps as last time, but at the

end, sub in inflation to get the output expression:

#
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
 -0 
w   - ¬  -   è -  ¬
 w 
 0 
-  - w  è -  ¬
 w 
 0 
-0 w è -0 - ¬ -    w   è -0 - 

w 

è -0 -  
0
èè -0 - w è -0 - ¬
 0 
  w  

w 

#   m
÷ The Barro-Gordon Model (BGM) is concerned
with what happens when the targeted level of
output ¶y· is 
 than ye.
÷ 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 kye)2 + (>  >
÷ Where ¶k· is a positive constant greater than one.

## ÷ IMPORTANT: REÚ LT £OLDÚ FOR

IAPC/EAPC AÚ WELL, B T IT TAKEÚ TIME.

#   m ÚRAÚ (ǑB)
LRAÚ
÷ The Diagram to the right shows the
effects of &'( ' )*+* (
Ǒ
( ,' , '*-  ). ÚRAÚ (Ǒ1)
)*+*/ E
÷ Initially we are at A with inflation ǑB
ǑT and output ye.
÷ £owever, the )0'1' 1 D ÚRAÚ (ǑT)
2, '3 32&3 )  '3
4)) )*+* ) 5 (i.e, move to Ǒ2
point B). C
÷ £owever, because they are
constrained to the ÚRAÚ curve, they
Ǒ1
will choose the optimal point along
it (C) as it is '('&- ) ,& A B
+.'2 2&2-. ǑT
÷ This leads to a higher inflation rate
Ǒ1 which shifts the ÚRAÚ curve up
next period.
÷ The economy will then move to
point D.
,& 2)'&'* *'&-
+)&' , a point on the LRAÚ
ye kye Y
curve.
÷ £ence, output ends up at ye and
inflation is higher than targeted.
÷  
& , 6
  /
   m
#
è
 
     J    

è | 

è
 
         ¬

   è  è    J  è  
¬  | 

  è  è    J  è    
 ¬ |


 è 0       è  J 
  ¬ |

     èJ  0
 ¬ |

0  
  m
#
÷ 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
EXPECTATIONÚ.
 |
  èJ  0  
 ¬
  
¬

0  

     èJ  0  
¬  |

## ÷ The size of the inflation bias, therefore, is 5

È 
÷ 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 ÚAME level of inflation.
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7
÷ 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 .&'& (1, with the end known
(elections). Thus, the game will ¶unravel· such that the
)0'1' 8&-- 92,: &(, 8.
÷ £ence the '- '5 ² no elections, therefore it is an
infinite game and there is no incentive to cheat.
÷ The Central Bank itself must 4*&-3 23&4&-& )0
&1; one possible way to do this is to tie itself to a
reputable central bank (Europe did this with the
BRndersbank).
÷ Another way of establishing credibility is for â 

  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       anyway in developed
capital markets ² although there are lags between the
stimulus and economic activity, there are NO lags between
the &1*-* '3 2+&- .-&(, that will follow, should
investors decide the stimulus signals a weakness in the
currency.