Political Economics LS–DES Prof. Guido Tabellini Final Exam January 2006 You have to answer both questions. Total time allowed: 2hours 30 minutes. Allocate your time in proportion to the weight given to each question 1. Credibility and Targets (70% of final grade) Consider an economy where the aggregate supply curve is: x = - e + - and aggregate demand is : = m. is inflation, m money growth (the instrument of monetary policy), x output in deviation from the steady state, and are two random variables not correlated with each other and with 0 mean, e is expected inflation conditional on , and >0 is a known parameter. Monetary policy is set under discretion, given e,, . The social loss function is L(,x) =1/2 * [2 + (x-x*)2] where > 0 and x* > 0 are known parameters. Before knowing the realization of and monetary policy is delegated to an independent central bank. According to the constitution, the central bank pursues social welfare, but is punished according to a “contract” defined over money growth, m, and conditional upon the realization of. Thus, the central bank sets m under discretion and so as to minimize: L(,x) – T(m,) (i) Derive the optimal contract from the point of view of society. (ii) Compare your answer with the optimal linear inflation contract. Are the terms of the contract identical or different? And is the equilibrium under the two contracts the same or not? Can you tell whether one contract is better than another? (iii) How would your answers to (i) and (ii) above change if we add a linear velocity shock v to aggregate demand? (iv) Retain the hypothesis under (iii) – namely there is a linear velocity shock to aggregate demand. Suppose that the optimal contract is forced to be “simple” – i.e., it cannot be conditional upon the realization of . Now the optimal (inflation or money contracts) are quadratic (in inflation or money). Which of the two contracts – money vs. inflation – is preferable, and why? You can answer this question intuitively, without providing a full derivation. 2. Electoral Cycles (30% of final grade) (i) Provide a short definition of “electoral business cycles” and briefly describe the empirical evidence regarding such cycles. (ii) Assume that voters are fully rational. Describe the settings (model ingredients) under which political business cycles (not partisan cycles) can arise. What are the key assumptions of such models and which are their main empirical predictions? Which model fits best with the empirical evidence?
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