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Interest Rate Rules, Barro-Gordon Model

The document discusses interest rate rules and central bank reaction functions. It derives equations showing the relationship between interest rates, inflation, and output. It also discusses how central banks can build credibility over time to reduce inflation bias by committing to clear and reputable policy rules. A lack of central bank credibility can lead to higher inflation outcomes.

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hishamsauk
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© Attribution Non-Commercial (BY-NC)
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818 views

Interest Rate Rules, Barro-Gordon Model

The document discusses interest rate rules and central bank reaction functions. It derives equations showing the relationship between interest rates, inflation, and output. It also discusses how central banks can build credibility over time to reduce inflation bias by committing to clear and reputable policy rules. A lack of central bank credibility can lead to higher inflation outcomes.

Uploaded by

hishamsauk
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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m m





    
m



  
÷ 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)

÷ Ǒt-1 - ǑT = (aǂ + a/ǂǃ)(rt ² rs)

÷ Thus, the above equation can be arranged to


arrive at:



  
÷ £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:

#
$    %

 -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 32&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.
# 


# m 
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 23&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.

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