Country : United Kingdom
Task



Question
Explain in detail two methods through which the time inconsistency problem of monetary economics can be solved?
The time inconsistency problem plays an important role towards assessing the effectiveness of a monetary policy, it makes it difficult for consumers to accurately predict the trend of inflation to be in line with their wages because governments are prone to suddenly implement an expansionary in other words cheating according to Kyland and Prescott with might offset the inflation forecasts which impacts their wages and labour force participation. This essay will assess whether economic solution such as the implementation of conservative central bankers and facilitating making the central banks independent, alongside inflation target will help offset the adverse effects of the conflicting government policies and it will also look at how consumers react to the unpredictable change of policies and how to impacts their lives at the time.The inconsistency problem causes issues when it comes to making a monetary policy effective in the long run, assuming that the central banks isn’t independent in this case meaning that It is run by the government, like it was back in the 1970’s for the UK. Moreover, looking at how the time inconsistency problem works, the government has liberty to influence output directly for their own benefit via giving a forecast to the consumers, workers on inflation. The government offer consumers an inflation forecast of 2% and interest rates at it decides in this in the scenario the government sets expansionary monetary policy by reducing interest rates to 2% and inflation forecasts at 4%. This would result in output increasing in the short run because worker inflation expectations are lower than the actual rate of inflation thus meaning that their real wages (W?) percentage increase haven’t caught up with to actual inflation and it lowers real wages for workers or inflation getting higher than wages, this is works to the advantage of the firms (employers) as the cost of hiring workers would decrease they would be able to hire more workers as it is cheaper to do so and therefore causing them increase their demand for workers through the government cheating as their haven’t kept the promise pf their initial policy of keeping inflation 2% from t+1 to t+3, instead they have set interest rate lower which results to inflation.


This abrupt expansionary monetary policy will help increase output in the short run, however workers will soon come to the realisation that their wages aren’t keeping up inflation because actual inflation is higher than expected inflation (?>?e), this results to workers increase their inflation expectations to equal that of the current market (?e=?). The inflation rate in this case will be 4%, this consequently results in real wages risings, this increases the cost of hiring workers for employers. This results in the reduction in the demand for labour at the new wage rate hence leading increasing unemployment, resulting in a fall output in the long run which returns to the initial level. Thus, inflation remains, leading to the standard of living for citizens to fall. The issue with the inconsistency problem is the inflationary bias associated with it after the government cheats. This brings distrust between citizens and the governments as the governments are prone to do this in during election time to by artificially increasing the performance of the economy to look for favourable and to win over voters at the expense of rising inflation.


Moving on how this works mathematically, looking at the aggregate supply function which is equation 1 see figure 1, it shows that output depends s on the long run level of output which is constant and it shows ?-?e if in the scenario that ?-?e>0 is positive firms will increase their output because the price of their goods and services are being sold greater than the expected value, conversely if ?-?e<0>

Question 2
Given the recent inflationary pressure, the Bank of England (BoE) may be required to change its monetary policy stance. Using appropriate theoretical and empirical support, explain the impact of such a policy change on aggregate loan supply and loan demand.
a) Using appropriate theoretical arguments, explain in detail whether the Bank of England should use the original Taylor rule to set policy rate.
b) Derive the Keynesian velocity of money. Explain what will happen to the Keynesian velocity of money if the central bank increases the policy rate.
c) The following information is given; real income, Y=100, price level, P=4, interest rate, i=0.8 and transaction cost F=10. Given these values and showing your workings clearly obtain, with accompanying explanatory discussion, the optimal amount of transactions, n, and also the average money holding or money demand, M, using the Baumol–Tobin inventory theoretic approach.

 


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  • Posted on : February 11th, 2020

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