The Phillips curve describing an economy takes the form u = uⁿ - α(π - Eπ). The central bank directly sets the inflation rate to minimize the following loss function, L (u, π) = u + γπ². The symbol u denotes the unemployment rates, uⁿ is the natural rate of unemployment, π is the inflation rate, Eπ is the expected inflation rate, and α and γ are behavioural response parameters of the economy. Private agents form their expectations rationally before the central bank sets the inflation rate. The optimal inflation rate when the central bank operates using a fixed rule will be _____. The optimal inflation rate when the central bank operates with discretion will be _____. A)uⁿ; 0 B)0; uⁿ C)0; α/(2γ) D)α/(2γ); 0

Question

Quizplus · Accepted Answer

When the central bank operates with a fixed rule, it sets inflation to minimize the loss function, leading to an optimal inflation rate of 0. With discretion, the central bank considers the trade-off between inflation and unemployment, resulting in an optimal inflation rate of α/(2γ).

The Phillips Curve Describing an Economy Takes the Form U