In the 1970s in Canada, the inflation rate and the natural rate of unemployment both rose. Let’s use this model of time inconsistency to examine this phenomenon. Assume that policy is discretionary.
In the model as developed so far, what happens to the inflation rate when the natural rate of unemployment rises?
Let’s now change the model slightly by supposing that the Bank of Canada’s loss function is quadratic in both inflation and unemployment. That is,
L(u, π) = u2 + γπ2.
Follow steps similar to those in the text to solve for the inflation rate under discretionary policy.
Now what happens to the inflation rate when the natural rate of unemployment rises?
In 1987, Prime Minister Brian Mulroney’s government appointed the conservative central banker John Crow to head the Bank of Canada. According to this model, what should have happened to inflation and unemployment?