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The Fed’s Loss Function
Inflation Hawk: Policymaker who is very concerned about inflation, more so than
the other goals.
Inflation Dove: Policymaker who is less concerned about inflation and more concerned
about other goals of the fed such as full employment and GDP growth.
The Fed’s Loss Function
L = - [α (π-π*)2 + β ( y-y*)2 ]
OR
L = -[α (π-π*)2 + β ( UR - NAIRU)2 ]
Where:
π = actual inflation rate
π* = target or “optimal” inflation rate
y = actual gdp growth
y*= potential (or optimal) gdp growth
α = parameter measuring the degree of “hawkishnish”
β = parameter measuring the degree of “dovishness”
UR = actual unemployment rate
NAIRU = non-accelerating inflation rate of unemployment
Be familiar with the following terms when interpreting the Fed’s loss function:
Inflation Targeting
Core PCE
Alpha
Beta
Stagflation
Hawks
Doves
Discuss Paul Volcker and his behavior during the second oil shock.
Discuss the reputation that Chairman Bernanke has acquired and why.
Be very clear about the 180 degree difference in policy between hawks and doves
in a stagflation environment. That is, in a stagflation environment, hawks and
doves would most definitely disagree.
October 12, 2004
American, Norwegian Win Nobel
Prescott, Kydland Honored
In Economics for Research
Crucial to Central Banking
By JON E. HILSENRATH
Staff Reporter of THE WALL STREET JOURNAL
October 12, 2004; Page A2
An American and a Norwegian were awarded the Nobel prize in economics for research
that laid the intellectual foundation for modern central banking and for their somewhat
controversial work that redefined how some economists think about the causes of
economic booms and busts.
The award went to Edward C. Prescott, 63 years old, an economics professor at Arizona
State University and longtime researcher with the Federal Reserve Bank of Minneapolis,
and his frequent collaborator Finn E. Kydland, 60, a Norwegian-born economist now on
faculty at Carnegie Mellon University in Pittsburgh and at the University of California at
Santa Barbara. Mr. Prescott has long been seen as a favorite to win the award; Mr.
Kydland has received less attention.
The Royal Swedish Academy of Sciences said the men's work has "profoundly
influenced the practice of economic policy in general and monetary policy in particular."
The reforms that central banks around the world undertook in part as a result of their
work "are an important factor underlying the recent period of low and stable inflation."
The main insight came in a paper called "Rules Rather than Discretion: The
Inconsistency of Optimal Plans," written in 1977. In that paper, the authors
examined how government policy makers invited long-term trouble when they
strayed from their goals to address short-run problems. They applied the theory to
everything from patent enforcement to federal disaster assistance, but it was in the area of
central banking that the ideas in the paper struck a chord. At the time, inflation was
running rampant and economic growth was stagnant -- a phenomenon called
"stagflation."
Most central bankers around the world typically espoused a
commitment to contain inflation, but in practice central bankers
would shift policy to tolerate a little more inflation in the short
run as a trade-off for stronger economic growth and rising
employment. The professors showed how these short-term shifts
in policy had long-term consequences and could push up
inflation expectations of households and businesses, leading to
long-running bouts of rising prices.
"Kydland and Prescott's analysis provided an explanation for
the failure to combat inflation in the 1970s," the academy said.
The key to any policy, they argued, was to make a commitment
and stick to it. Central bankers responded by demanding more
independence, so that they would be less prone to interference by elected officials
who were concerned about short-term fluctuations in the economy. It also led many
central banks -- such as those of New Zealand, Sweden and the U.K. -- to adopt
formal inflation targets to underline the commitment to low inflation. "You should
not
think in terms of controlling the economy," Mr. Prescott says. "That
leads to bad outcomes. You should think in terms of committing to
good policy rules."
Their research into business cycles has been more contentious. Before
the authors took up the subject in a 1982 paper, many economists
believed that economic booms and busts were caused by changes in
demand by consumers and businesses, a point espoused by John
Maynard Keynes, whose views dominated economic thought after the
Great Depression. Mr. Keynes prescribed government stimulus when
consumer spending or business investment softened.
But Messrs. Prescott and Kydland, who were the forefront of a broad shift
away from the teachings of Keynes, argued that other factors, most notably a nation's
productivity, were critical driving forces in short-term shifts in the business cycle. They
theorized that supply-side shocks, such as a new technological innovation or a surge in
the price of oil, could alter productivity patterns and cause a recession or an economic
boom. Before their work, economists thought productivity of a nation's work force
mainly affected long-term economic performance.
Those views about the business cycle may seem straightforward, but they remain
contentious even today, in part because they undercut arguments for the government to
act to stimulate demand when the economy weakens. Lawrence Summers, the president
of Harvard and the former U.S. Treasury secretary, once wrote that the work of Messrs.
Prescott and Kydland on business cycles had "nothing to do with the business-cycle
phenomena observed in the United States or other capitalist economies." In an e-mail
yesterday, Mr. Summers said the two professors "richly deserve" the prize because of the
economic methods they introduced, even though "I like many others find their particular
theories [about business cycles] implausible."
Messrs. Prescott and Kydland will share an award of 10 million Swedish kronor, or $1.4
million. The award is officially called the Bank of Sweden Prize in Economic Sciences in
Memory of Alfred Nobel. It is the last of six prizes announced by the Royal Swedish
Academy of Sciences; the others were all announced last week.
Write to Jon E. Hilsenrath at [email protected]
Two majors points to emphasize: 1) Prescott and Kydland won noble prize for hands off
policy prescription; and 2) their work on real Business cycle analysis is contentious.
Applications to the Aggregate Supply / Aggregate Demand Model
1. In the space below – Draw an aggregate supply / aggregate demand diagram and label the initial
equilibrium point as point A (assume this point is also consistent with full employment GDP).
Consider the contributions by Kydland and Prescott – that is, show how the policy makers have an
incentive to cheat by stimulating aggregate demand to stimulate GDP beyond its potential. Label this
point B. Point B is a short-run equilibrium and is not consistent with a long run equilibrium since we
assume that potential output is driven by supply side factors.1 Now let wages rise and show what
happens to equilibrium GDP and the equilibrium price level. Label this point as point C. Which do
you prefer – point A or point C. Use the loss function that we developed in class to buttress your
argument.
1
Most if not all economists agree with the notion that potential output is driven by the production function
which is typically a function of total factor productivity, labor, capital, and land resources.
In the space below, draw two diagrams depicting the contribution of Kydland and
Prescott. On the first diagram, use indifference curves and show how society is worse off
if policy makers ‘cheat’ by trying to stimulate output beyond its potential. In the second
diagram, show that the Phillips curve is vertical as opposed to being negatively sloped as
was previously thought.