TIME CONSISTENT MACROECONOMIC POLICY Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

OUTLINE INFLATION MACROECONOMIC MODEL A SIMPLE MACROECONOMIC MODEL MATHEMATICAL IDENTITIES ORDER OF PLAY AND EQUILIBRIUM PAYOFFS EXAMPLES AND PRECOMMITMENT Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

INFLATION Inflation is a persistent increase in the general price level. Continuous increase in general price level and large amount of goods are subjects for inflation. Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

A SIMPLE MACROECONOMIC MODEL Interdependency among 3 groups: Workers Central Bank Employers Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

Indexation has 2 important implications: Wage contracts are indexed to prices but the indexation of wages to prices is not complete. Indexation has 2 important implications: 1-)The money wage that clears the labor market will depend on the rate of inflation expected over the period covered by the contract. 2-)If the inflation rate actually differs from what was expected when the money wage was negotiated,then workers will be forced by their contracts to supply either more or less labor than they would have supplied had the inflation rate been correctly foreseen. Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

Mathematical Identities Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

ORDER OF PLAY There are 2 time periods. At the first time period,the workers choose the money wage. At the beginning of the second period,the central bank chooses the rate of inflation. The employers then choose the level of employment. Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

PAYOFFS Workers are utility maximizers who value both real income and leisure. Is(rt) = α * rt rt = wt-пt rt is real wage wt is nominal wage пt is inflation ratio Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

Payoff function for workers: Vw = -(I2-α *(w2-п2))2 Payoff function for Central Bank: WCB = -(I2-I-2)2-ч*(п2-п-2)2 Payoff function for employers: Ld(rt)=-n*rt Ld(r2) = n*(п2-w2) VE =-(I2-n*(п2-w2))2 Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

The labor market is in equlibrium when the labor supply equals to labor demand.At this equilibrium,the level of employment is the natural level of employment. Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

EQUILIBRIUM In this dynamic game,employers move last. Given the money wage chosen by the workers and the rate of inflation chosen by the central bank, the employer’s profit maximizing strategy maximizes pay-off function for employers. Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

This equation shows aggregate employment function. I*2 =n*(п2-w2) This equation shows aggregate employment function. I*2 shows the optimal level of employment. The workers move first.Their choice depends on their forecasts about employment and inflation rates. Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

The inflation forecasts are called as inflationary expectations. Vw =-(I*2(w2,п*2(w2))- α*(w2-п*2(w2))2 =-(n+α)2 *(п*2(w2)-w2)2 w*2=п-2 +n/ ч *I-2 Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

Since п*2(w*2) =w*2 ; Ld=Ls П*2(w*2)=п-2 +n/ ч *I-2 Since п*2(w*2) =w*2 ; Ld=Ls Finally, the central bank can reach inflation and employment targets if I-2=0 Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

Reasons for higher target level of employment Taxes on income Unemployment compensation Monopolistic unions Monoponistic employers pay wages below the competitive level,thereby reducing the quantity of labor supplied. Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

Whenever the target level of employment is positive,the central bank misses its employment target and its inflation target. Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory

Assoc. Prof. Yeşim Kuştepeli, ECN 4015 Game Theory