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÷ An interest rate rule gives a direct relationship
between the primary tool of a Central Bank (the
interest rate) and inflation and output.
÷ It is essentially the maths behind the three-
equation model developed previously.
÷ We shall therefore be using the following
equations:
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÷ Úubstitute the IAPC into the MR;
÷ Ǒt-1 + ǂ(yt ² ye) ² ǑT = -(1/ǂǃ)(yt ² ye)
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÷ The Barro-Gordon Model (BGM) is concerned
with what happens when the targeted level of
output ¶y· is
than ye.
÷ Next slide derives it diagrammatically and it is
derived mathematically following that.
÷ Assume, however, that there is a Lucas ¶surprise·
supply function and a loss function of the form:
÷ L = (y ² kye)2 + (> >
÷ Where ¶k· is a positive constant greater than one.
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÷ That equation describes the reaction function
(the grey line in the previous diagram). In order
to find what rate will be selected, we must TAKE
EXPECTATIONÚ.
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