Suppose that the tradeoff between unemployment and inflation is determined by the Phillips curve:
u = un – α(π – Eπ ),
where u denotes the unemployment rate, πn the natural rate of unemployment, π the rate of inflation, and Eπ the expected rate of inflation. In addition, suppose that the country involves two political parties, the Left and the Right. Suppose that the Left party always follows a policy of high money growth and the Right party always follows a policy of low money growth. What “political business cycle” pattern of inflation and unemployment would you predict under the following conditions?
Every four years, one of the parties takes control based on a random flip of a coin. [Hint: What will expected inflation be prior to the election?]
The two parties take turns.
When cities pass laws limiting the rent landlords can charge on apartments, the laws usually apply to existing buildings and exempt any buildings not yet built. Advocates of rent control argue that this exemption ensures that rent control does not discourage the construction of new housing. Evaluate this argument in light of the time-inconsistency problem.
The cyclically adjusted budget deficit is the budget deficit corrected for the effects of the business cycle. In other words, it is the budget deficit that the government would be running if unemployment were at the natural rate. (It is also called the full-employment budget deficit.) Some economists have proposed the rule that the cyclically adjusted budget deficit always be balanced. Compare this proposal to a strict balanced-budget rule. Which is preferable? What problems do you see with the rule requiring a balanced cyclically adjusted budget?