Question 2 {10 marks) You are a political economist working for a political party and your team has been tasked with working out permutations regarding steps governments may take with respect to maximising their utility but also to account for how the public will react, assuming the public behave in a manner described within the rational expectations paradigm. The aggregate supply curve in your country is equal to: Y = Y* + P EP =(1} Where Y* is the long-term equilibrium level of output, P is the price level and EP is the expected price level. The government's utility function is: UG = -l2l.75P2 + Y Y* _[2} The public's utility function is: Up = -(P-EP}31 _(3} (a) Your political party is attempting to decipher the appropriate price level that a government would prefer to see in place in the economy. If the government ignores the public's expectation of prices, what price level would maximise its utility, the options being P=0, P=1, P=2 and P=3? Show your workings and explain why you chose the value of price that you did. (3 marks} (b) The political party i; however, well-aware that to be successful in the long-run, the pricing policy must leave the public better-off, or at least no worse off in terms of the public's utility. As the public is rational, what expected price would the public form given their knowledge of the government preference? What would the public's level of utility be, and is this level of utility going to leave the public at least no worse off in terms oftheir utility? (3 marks} (c} If the government commits to set the price level at P=2, is this commitment dynamically consistent from the point of view of the public? Explain your answer. (2 marks} (d) Looking back at (c}, now assume that adaptive expectations apply and the government has, in the past set P=2. Is the government's statement to set the price level at P=2 credible in the eyes of the public? Explain your answer. (2 marks}