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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.