Question

Consider the following model Lucas Aggregate supply curve developed by Kydland and Prescott (JPE, 1977):

A)Explain why a policy of selecting the optimal level of inflation is not time consistent when the central bank is unable to commit to it.

B)Consider the case where the policymaker is able to commit to a level of inflation. Describe and explain the effect a change in a has on the level of inflation.

C)Do the same as in question (b), but for the case where the policymaker is unable to commit to a level of inflation.

Answer 1

A. The Lucas Model shows the trade-off between output and prices. It indicates that the effect of policy on inflation and output depends on expectations. The time inconsistency arise because the policymakers have to follow a set plan that help them to achieve long-run outcomes.

B. The more credible the policy makers who pursue an anti-inflation policy, the more successful that policy will be. The suppliers had to respond to a problem when making decisions based on prices; the firms had to determine what portion of price changes reflects a change in inflation and what portion reflected a change in real prices for inputs and outputs. The suppliers know their own industries better than the general economy. The surprise (rise in price) leads to an increase in production and employment.

C. The aggregate supply equation states that output exceeds natural output when the rpice level is greater than the expected price level.