Political expectations, inflation, and unemployment Consider a country with two political parties, Democrats and Republicans. Democrats care more about unemployment than Republicans, and Republicans care more about inflation than Democrats. When Democrats are in power, they choose an inflation rate of \(\pi_{D}\), and when Republicans are in power, they choose an inflation rate of \(\pi_{R}\). We assume that

An election is about to be held. Assume that expectations about inflation for the coming year (represented by \(\pi_{t}^{e}\) ) are formed before the election. (Essentially, this assumption means that wages for the coming year are set before the election.) Moreover, Democrats and Republicans have an equal chance of winning the election.

a. Solve for expected inflation, in terms of \(\pi_{D}\) and \(\pi_{R}\).

b. Suppose the Democrats win the election and implement their target inflation rate, \(\pi_{D}\). Given your solution for expected inflation in part

a, how will the unemployment rate compare to the natural rate of unemployment?

c. Suppose the Republicans win the election and implement their target inflation rate, \(\pi_{R}\). Given your solution for expected inflation in part

a, how will the unemployment rate compare to the natural rate of unemployment?

d. Do these results fit the evidence in Table 21-1? Why or why not?

e. Now suppose that everyone expects the Democrats to win the election, and the Democrats indeed win. If the Democrats implement their target inflation rate, how will the unemployment rate compare to the natural rate?

f. If the central bank sets an inflation target and monetary policy is not affected by who wins the election because the central bank is independent, do the preferences of the Republicans and Democrats matter? If the Federal Reserve were truly independent, how would we explain the results in Table 21-1?

Data from Table 21-1

Transcribed Image Text:

The Phillips curve is given by - (uun)