Hi there I could some help with this one I have bolded the question. Below that are some notes and resources to provide context and resources. The explanation needs to be addressed from the attached notes below question. Thanks.

In considering the response to this question, please be sure to keep in mind the definitions of inflation gap (defined as -*, or the distance of inflation from the desired level of inflation *) and output gap (defined as y minus y-bar, or the deviation of (log of) aggregate output y from (log) production capacity y-bar). (These are also defined in Background Notes, Module 8, p. 1).

Under the optimal monetary policy, the central bank should let the nominal interest rate

a.rise when the inflation gap rises and decline when the output gap rises.

b.decline when the inflation gap rises and rise when the output gap rises.

c.decline when the inflation gap or the output gap rises.

d.rise when the inflation gap or the output gap rises.

e.rise only when the inflation gap rises.

8.1.IntroductionIn this module, we address the following questions: o What are the characteristics of a desirable monetary policy? o What are the desirable levels of government spending, tax revenue, and public debt? o Are actual fiscal and monetary policies optimal? If not, in what ways actual policies deviate from optimal ones? o What factors drive the actual fiscal and monetary policies? o What are the roles of politics and institutions in macroeconomic policies? o How institutional reform may improve fiscal and monetary policies?Some terminology o Inflation gap, - : The distance of inflation, , from the desired level of inflation, .In developed countries, is usually set about 2 percent per year.The inflation targets in developing countries vary, but tend to be higher. o Output gap, : The deviation of (log) of aggregate output, ,from (log) production capacity, . 8.2. Desirable Macroeconomic PoliciesIn an ideal world, where everyone can foresee and take account of all possible contingencies, the economy will always work at full capacity and there is no need macroeconomic management other than steps that many be needed to enhance long-term growth.In the real world, where unforeseen events are a matter of fact, contracts cannot allow for all contingencies and will necessarily be rather rigid. As a result, the economy may perform sub-optimally if there is no policy intervention.In that case, it is desirable to be able to use expansionary fiscal and monetary policies when the economy faces significant negative aggregate demand shocks, compensated by contractionary policies when positive demand shocks materialize. Macroeconomics Background Note 8 2The response to supply shocks must be to let the economy adjust to them smoothly so that the economy does not overreact or destabilize when its conditions change in unforeseen ways.These rules may seem easily to follow and implement. However, in practice the issues become quite complicated because: o Identifying the nature of shocks and their magnitude and duration could be difficult. o Designing and implementing appropriate responses to shocks are also complex because the parameters and the structures of economic systems change and, as a result, are not known at the time when policy is being made. o The politicians may not have the right incentives to implement appropriate policies even if they may know the correct response to shocks.In the following, we first examine more specific characteristics of optimal monetary and fiscal policies, given the imperfections of the real world. The other issues will be discussed in more detail and their implications for the design of appropriate policy framework will be derived in later sections. 8.2.1. Some Characteristics of Desirable Monetary PolicyThe primary goal of monetary policy should be price stability.Taylor Rule: Moving interest rates in proportion to the inflation and output gaps. o Monetary tightening in response to rising inflation and vice versa o Also, monetary tightening when current output exceeds production capacity and loosening when current output falls short.Anticipating future inflation, which responds to the output gap with a delay 8.2.2. Some Characteristics of Desirable Fiscal PolicyAverage tax rate should remain stable over time as much as possible. o Due to deadweight losses, cost of taxation rises faster than the tax rate. o To avoid high tax rates in times when high expenditure becomes necessary, tax rates need to be smoothed.Government expenditure can proceed as needed and be smoothed over time when possible.Longrun fiscal policy should ensure that the government is solvent and not credit constrained.Shocks to expenditure or tax revenue should be spread over longterm horizons. o Fiscal shocks should translate into changes in public debt.Changes in public debt should be ... Macroeconomics Background Note 8 3 ... independent of the existing levels of debt and government size! ... countercyclical, especially if fiscal policy is countercyclical for stabilization purposes. 8.3. Macroeconomic Policies and Political DecisionMakingDo politicians try to manipulate macroeconomic policies for their own political ends?While the government and the central bank may be able to improve economic performance by steering fiscal and monetary policies according to optimal rules, they may not have the incentive to do so. Indeed, misuse of macroeconomic policies itself is sometimes an important source of instability. This happens when the institutions governing policymaking fail to provide the politicians with the right incentives to conduct policy in ways that ensure stability and growth for the economy as a whole. o For example, at election times, incumbent politicians may find it worthwhile to increase government expenditure, either because they want to buy out supporters or toimpression that the economy is doing well under their management and employment and incomes are rising. When the politicians have control over the central bank, they can also use monetary expansion to lower interest rates and, thus, make some voters happy for a while.The time horizons of politicians often put bigger weights on shorter terms, particularly the time till the next election, than are optimal for the society. This distorts their policy choices and causes deviation from optimal policy. o This effect also exacerbates the "time-inconsistency" problem in macroeconomic policy, particularly because the expected and actual turnover weakens commitment capabilities of policymakers.The extent and type of manipulation varies across countries. o It depends on the incentives created by the country's institutions and politics.There is a great deal of evidence that macroeconomic policies in many developing countries tend to be pro-cyclical, rather than counter-cyclical. Political business cycles (in which government spending and money creation are used to create jobs or buy votes around election times) are also often prominent in many countries. o Indeed, dealing with the problems caused by such policies have shaped the fiscal and monetary institutions of the countries that have tried to address the relevant issues (e.g., formation of independent central banks, which we will discuss below).For evidence of political considerations in setting fiscal policy, Figure 8.1 presents the example of budget deficits in the Philippines since 1950s. The Figure show clearly that the deficit used to rise sharply around the time of every presidential election in the Philippines. Though the country's political institutions have undergone transformations in the 1970s and 1980s, the deficits still tend to be high before and during presidential election years. Macroeconomics Background Note 8 4Figure 8.2 provides further evidence from changes in state employment around the times of gubernatorial elections in the United States. It shows that on average, state governments in the US double the rate of growth of employment in their bureaucracies during election years and compensate for it by freezing employment in the years following elections. Figure 8.1. Government Budget Surplus as Percent of GDP in the Philippines Note: Vertical lines show election years. Years refer to fiscal years ending in June. Elections in 1972 and 1977 were constitutional and major congressional elections. No presidential elections were held during 1972-1981 due to marshal law conditions. Figure 8.2. Percentage Change in State Employment around Gubernatorial Elections in the United States Macroeconomics Background Note 8 5On the whole, in the case of developed countries, there is empirical evidence of use of optimal monetary policy and some aspects of the optimal fiscal policy, particular counter-cyclical responses and the use of public debt to deal with fiscal shocks. o The magnitude of countercyclical debt response is significantly larger than that implied by the theory possibly due to stabilization policies, offbudget liabilities, and political motives.In developing countries, monetary and especially fiscal policies are often procyclical! o Institutional and political factors matter. 8.4. Political Economy of Macroeconomic Policies 8.4.1. Key Political Economy Concerns o Monetary policy may be used to finance deficits or to subsidize credit. o Politicians may channel part of fiscal resources towards particularistic interests to buy support. o Fiscal policy may suffer from the "tragedy of commons":Excessive spending and borrowing as different interest groups try to capture more of the budget pool. o Sustainability problems and credit constraints 8.4.2. Political Economy, Expectations, and InstabilityWhen pro-cyclical policies push the economy above production capacity, inflation rises and is followed by a decline in equilibrium income as the economy returns to its capacity limit. But, the problem does not end there! o If people expect the politicians to manipulate policies for their own ends, they try to anticipate the outcome and take it into account. For example, when people believe that the central bank has an incentive to print a lot of money and finance the government deficit, they may come to expect high inflation and incorporate it into their implicit and explicit contracts.Such expectations by themselves raise the current price level and may give rise to stagflation.This could further induce the politicians to actually employ expansionary policies and boost the demand and create inflation to avoid a recession, even if they did not plan to do so!Even if the politicians do not intend to use inflationary policies, the public's expectations may become self-fulfilling and lead to increased inflation. o Things can get worse! When people don't trust the incentives of the politicians, they may rationally conclude that the politicians will go beyond responding the adverse impact of expectation and try to expand demand even further to reach their own aims. Then the natural response on the part of the Macroeconomics Background Note 8 6 public is to expect an even worse outcome, inducing the politicians to go for even more expansionary policies. o If the politicians try to avoid the consequent recession by continuing to raise demand, prices will accelerate and inflation can soon get out of hand, sooner or later leading to major economic instability and crisis. o This may particularly be the outcome if people see their expectations fulfilled about expansionary policies and start anticipating even higher inflation rates in their economic decision-making. o At some point, prices may end up running ahead of demand increases, shifting the IS and LM curves leftward.An important consequence of the process described above could be erosion of confidence in the economic system and its policymaking institutions. This can act as an adverse supply shock because when the potential for destabilizing policy decision is high, the participants in the economy may restrict their contracts and lower their investments to protect themselves against adverse policy changes (e.g., higher taxes, higher interest rates, or accelerating inflation). The outcome is undesirable because it implies wasteful investments, loss of some beneficial investments, and idleness of some useful resources, paradoxically combined with high costs of production. o A notable aspect of this phenomenon is that in the end the policy-makers may not gain anything from expansionary policies that they use for propping up the economy. o In fact, if their discretion to use such policies could be taken away, destabilizing expectations might be contained and the economy could perform better. Just the fact that discretion is there can impose significant costs on the economy!Economies facing such risks also find themselves credit constrained. Creditors, especially the ones with greater resources that operate in international markets are often reluctant to lend to countries with major instability prospects.Macroeconomic stability and performance require policymaking institutions that align the incentives of decision makers with the long-term performance of the economy. 8.4.3. The Political and Institutional Context of Macroeconomic PolicymakingThe political process through which economic policy is made typically entails three types of conflicts of interest: o Policy makers may abuse their power in office and capture public funds for their own benefit at the voters' expense. o Different groups of voters disagree on the allocation of tax revenues. o The political representatives disagree over the distribution of current and future rents. Macroeconomics Background Note 8 7These conflicts of interest are resolved in different ways under different constitutions.Political constitutions are incomplete contracts. o A constitution can specify an allocation of decisionmaking authority only to specific groups or individuals: ... who makes policy proposals; ... who can approve, amend, or veto them; ... and who appoints the representatives exercising this authority. o The outcome hinges on how and by whom the authority to make policy is exercised and under what circumstances. The circumstances include, for instance,Plurality vs. proportional representation in electoral systems determines the narrowness of representation and the incentives of politicians to focus on particular ranges of interests (usually in the middle of political spectrum) or to respond to broader interests.Separation of powers vs. flexibility in policymaking determines the extent of checks and balances, which can limit the abuse of power and increase the accountability of elected policy makers at the cost of reducing their ability to respond to economic shocks quickly and effectively (when they have the right incentives).Constraints on policymaking vs. reward for policy performance is an important trade-off. To curb the abuse of power by the politicians, constitutions, laws, and institutions more generally may be set up in ways that impose constraints on their discretion. Alternatively, the rules and the process may be set up to creative appropriate incentives for the politicians to adopt socially beneficial policies. However, getting such mechanisms to work is not easy, hence the tradeoff. o An important example: the difference between two types of democracies (presidentialcongressional vs. parliamentary regimes) and two kinds of electoral system (plurality vs. proportional representation). 8.4.4. PresidentialCongressional vs. Parliamentary SystemsPresidentialcongressional systems are associated with greater separation of powers and less proportional representation. (See the next section for a more detailed discussion of the role of electoral systems.)Presidentialcongressional regimes allow for greater separation of powers because they provide separate direct elections for the executive and legislature. o Separation of powers can limit the abuse of power and increase the accountability of elected policymakers.Voters can take advantage of conflicts of interest among different office holders and reduce the agency problem of politicians. Macroeconomics Background Note 8 8 o Moreover, congressional committees have power over different policy dimensions, hence further dividing power within the legislature.As a result, legislative majorities often change from issue to issue.Analysis by Persson, Roland, and Tabellini (2000)1 , among others, shows that the separation of powers in the presidential-congressional regimes produce ... ... smaller governments, ... with less waste, less rents for the politicians, and less redistribution, ... but also inefficiently low spending on public goods. o Separation of powers enables voters to discipline the politicians, which reduces waste and moderates the tax burden. o The checks and balances in presidential-congressional regimes allow voter groups to deal more effectively with the agency problem of politicians and to reduce the rents that they may extract for themselves from government funds and resources. o However, the same factors also mean that each interest group will be trying to get politicians to spend for its own particular interest. Under presidential systems, the executive elections focus on the median voter and those in the middle of the political spectrum. This reduces the range of interest groups that receive attention and benefits from the government. These groups do not fully internalize the benefits of public goods that improve the economic conditions for the population at large.So, projects such as public transportation, public education, and social insurance tend to get relatively less funding under presidential than parliamentary systems. (Parliamentary system tend to allow for more proportional representation where many parties participate in policymaking and get the voices of more groups heard.)Parliamentary regimes tend to be associated with greater proportional representation and with more legislative cohesion. The result is ... more public goods and larger and more universalistic welfare programs, ... larger overall government sizes with more taxation and more waste, o In parliamentary regimes, there is more scope for collusion among politicians, which increases waste and taxation. o But policymakers have a greater incentive to please a larger group of voters with increased public good provision and more equal redistribution to generate support for higher levels of taxation. 1 Torsten Persson, Grard Roland, and Guido Tabellini. 2000. "Comparative politics and public finance", Journal of Political Economy, 108: 1121-1161. See also Torsten Persson and Guido Tabellini. 2004. "Constitutional Rules and Fiscal Policy Outcomes," The American Economic Review, 94.1: 25-45. Macroeconomics Background Note 8 9These results can help explain why the size of government in presidentialcongressional regimes is smaller than in parliamentary regimes by about 10 percent of GDP.There is also evidence of differences in the composition of public spending across regimes, though the empirical result is not as strong as the one regarding the size of government.To conclude, these findings point to a tradeoff in institutional design: o Presidential regimes perform better in terms of accountability because they deal more effectively with the agency problem between voters and politicians. o Parliamentary regimes are better for publicgood provision because they solve the conflict between groups of voters more effectively. 8.4.5. Electoral Rules and Fiscal Policy OutcomesProportional elections tilt the composition of public spending towards program benefiting large groups in the population, such as public goods or universalistic welfare programs. o One mechanism for proportional representation is larger district magnitude (number of representatives per district, which means that a politician can get elected with a small share of the vote. (If district magnitude is m, share 1/m of the vote is sufficient for a candidate to get elected, though smaller shares may also work if top vote receivers have large shares.)With proportional elections, legislators are elected in larger districts, enabling smaller interest groups to get represented and giving parties strong incentives to seek support from broad coalitions in the population.Plurality rules are applied in smaller districts, inducing politicians to target smaller, but pivotal, constituencies (usually in the middle of the polity spectrum).Details of electoral formulas matter (how vote shares are converted to seat shares in the legislature).The size of the minimal coalition of voters needed to win the election is smaller under plurality rules.Under a plurality electoral system, a party can win a majority with about 25 percent of the national vote: 50 percent in 50 percent of the districts. o Under a full proportional representation system, a party needs 50 percent of the national vote to win majority of seats in the legislature.Electoral rules have many other details, with consequences for fiscal policy and corruption. o Using party lists increases corruption, especially closed lists!Plurality rules in elections are associated with fewer parties. o Plurality rules in parliamentary systems are more likely to produce singleparty majority governments. Macroeconomics Background Note 8 10Coalition and minority governments are more likely under proportional elections. o This can lead to a more serious commonpool problem, leading to a larger government spending. 8.4.6. Constraints on Policymaking vs. Reward for PerformanceAnother institutional dimension that matters for macroeconomic policymaking and will be discussed further below is the use of constraints on policymaking vs. discretion associated with reward for performance.Policymaking constraints, such as constitutional restrictions on public debt or deficit, could help limit opportunistic behavior among policymakers. But, they also restrict responses to complex and unforeseen situations that may arise in complex economic systems. Setting targets, allowing discretion, and offering rewards for good performance may work better in some situations. But, that depends on how well the goals may be defined and the targets and rewards can be enforced. o There is no perfect solution in a highly complex world.Given all such tradeoffs, one may consider the following questions that have no easy and general answers: o Which institutional setting is better for an underdeveloped, emerging, or developed economy? o Which one is better for a country with heterogeneous or factionalized population? o Which one is better for a country with significant natural resources? 8.5. How Can Countries Commit to Good Macroeconomic Policies? 8.5.1. RuleBased Policy RestrictionsMonetary policy o Constant growth rate rule for money supply o Currency board: fixed exchange rate and endogenous money supplyFiscal policy o Balanced budget laws o Golden ruleRule-based policy-making is one way of achieving policy stability by making macroeconomic policy subject to fixed rules, such as a constant growth rate of money supply or a maximum allowable budget deficit (e.g., balance budget laws).With a constant growth rate for money, money supply becomes exogenous. During recessions, demand for money falls and the growing money supply lowers the interest rate and automatically boosts demand. Macroeconomics Background Note 8 11 During booms, income will be growing fast and money supply will lag behind, forcing interest rates to rise and automatically slow down the economy.Currency boards that apply a pre-determined fixed exchange rate are also another form of rule-based policy for money supply. In this case, domestic money is issued only if someone who owns foreign currency submits his money to the board and demands domestic currency. Money supply shrinks if people want to take their financial assets out of the country and demand foreign currency in exchange for domestic currency. The board has to honor all such requests.If policy is dictated by rules, then only automatic stabilizers (e.g., unemployment benefits and taxes that vary with income) can be used and there will be no room for adjusting policy according to specific situations when the range of possible circumstances is complex.This solves the ability of the politicians to manipulate policies, but it also takes away policy discretion, which offers greater flexibility in dealing with complex economic shocks that cannot be entirely anticipated in policy rules.Rules can prove quite costly to the economy. For example, balance budget laws for the government to cut expenditure during recessions when fiscal expansion may be quite desirable for counteracting with adverse demand shocks.Under currency board, when the country experiences an increase in import prices or decline in export prices, investors may come to believe that it may not have enough foreign currency to honor its commitment to the exchange rate. In that case, they will take their money out of the country and deprive it of foreign currency when the economy needs it most. Such shortage of foreign exchange may cause a sharp drop in production. It may eventually bring the country to its knees and lead to default in foreign debt. This is, indeed, what happened in Argentina during the late 1990s and early 2000s.For these reasons, many economists have come to the conclusion that the benefits of rule-based policies are limited. 8.5.2. Delegation and DiscretionMonetary policy o Independent Central Bank o Inflation targetingFiscal policy o Powerful Finance Minister o National Debt BoardA solution to the dilemma of policymaking is to delegate authority over certain policies, as in the case of central bank independence. The idea is to have a professional with a long term horizon and incentives Macroeconomics Background Note 8 12 that are aligned with those of the economy as a howl make the policy decisions, rather than leaving the task to politicians or simple rules.Appointing an independent central bank governor with discretion over monetary policy, but ensuring that he has the incentive or the preference to keep inflation low. o This arrangement is in contrast to the situation in most countries where the central bank governor is an agent of the politicians, who ultimately determines the central bank's decisions. It is also in contrast to the currency board arrangements in which the central bank plays no role in money supply except issuing currency to exactly match the country's reserves. Under currency boards, an adverse shock to the economy could be considerably exacerbated by an outflow of capital that reduces money supply and raises interest rates sharply. o However, countries that have managed to guarantee the independence of the central bank have generally experienced low inflation rates.For fiscal policy, delegation has generally taken the form of giving the finance minister (or a similar office) a great deal of authority in the design and implementation of the government budget. The caveat in this is that the finance minister is often a politician as well and may be tempted to take advantage or his/her authority to manipulate the budget in favor of the ruling party or group of politicians. However, in most cases, this is still an improvement over allowing the spending ministers or members of the legislature who directly benefit from government expenditure decide on their own budgets!A new form of delegation over fiscal policy that has been proposed but has not been implemented in any country is to have a "national debt board," which would function very much like an independent central bank but its task would be to set limits on budget deficit and national debt.It should be pointed out that constraining policy by means of rules or giving independence to institutions such as the central bank and the proposed national debt board is not an option in many countries. Such arrangements require a minimum degree of rule of law, which is lacking in many developing countries. Certainly, policy rules and constitutional restrictions are meaningless in many dictatorships. In these situations, policies often depend on individuals and personalities, and one cannot count on things beyond the political leaders' horizon in office. In Indonesia, a great deal of doubt grew about economic policy as the former dictator Suharto grew older and everyone started asking what would happen afterwards. 8.6. ConclusionMacroeconomic stabilization policies should focus on preventing disasters, not fine tuning the economy!It is important to allow for discretion in policymaking, but to ensure accountability and checks and balances.Reaching coordination across policies, especially fiscal and monetary policies, is essential. Macroeconomics Background Note 8 13The presence of automatic stabilizers in the policy framework can help reduce discretion while maintaining some policy responsiveness to economic fluctuations. Examples are:Income taxesUnemployment insurance o As the economy expands, income taxes rise and unemployment insurance payments decline, automatically acting as contractionary policies. Similarly, these mechanisms contribute to stabilization on downturn.