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Economic Analysis and Policy_Coursework - Essay Example

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Name: University Course: Instructor: Date: Macroeconomics (Question a) There is always much debate on the concept of rule versus discretion in regulating aggregate demand. The origin of this debate is traced back to Milton Friedman’s assertion that the Federal Reserve should increase money supply in the economy by a fixed rate annually as opposed to the traditional approach where there was much discretion on the issue of money supply…
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Economic Analysis and Policy_Coursework

Download file to see previous pages... In terms of agent’s utility, discretion based solutions are normally the best. On the other hand, policy options that are based on rules usually have little room for policy errors. However, such an approach requires a lot of confidence that the variables will perform as intended without any challenges. This is certainly difficult to realize for inflation targeting especially in the identification of financial stability (Langdana, 2009). Indeed, most rule-based approaches have faced many challenges especially when applied as an inflation target framework. In this respect, a discretionary framework is always appropriate in addressing the issue. It allows policy makers to learn much from the interaction between various relevant stakeholders. Nevertheless, it should be realized that the adaptability and flexibility of discretion comes with its own share of costs. There is limited predictability of the decision in addition to a tendency toward forbearance as policy makers are tempted to postpone backfiring decisions. In most rule-based approaches, policy reactions are normally left to some pre-defined automatic triggers and mechanisms. However, the use of rules might be difficult especially for a new policy which should be used across the world (Peston, 2010). (Question b) Indeed, the Taylor rule has greatly revolutionized the manner in which policy makers and central banks approach the issue of monetary policy. It frames policy actions in line with the various incoming information regarding economic conditions. In this case its contrasts the traditional period-by-period optimization problem. The rule has greatly brought into focus the need for adjusting policy rates more than one-for-one in responding to increased inflation. The rule is therefore used in adjusting prudent interest rates which can help in stabilizing the economy both in the short term and maintain growth in the long term. This is much opposed to inflation targeting which basically focuses on estimation of the inflation rates and attempting to fix the situation through interest rates (Barro, 2005). The attractiveness of the rule arises out of its ability to foster price stability and ensure full employment through a reduction of uncertainty. It further increases the credibility of future actions of the central bank. The rule might further avoid most inefficiency associated with time inconsistency through the use of discretionary policy. The Taylor rule indeed provided a compromise between the various competing schools of thought in a proper language often lacking in rhetorical passion. A recent application of the Taylor rule was made by the Federal Open Market Committee (FOMC) after inflation was seen to have risen by 2%. The rule provided a quantitative prescription on how the interest rates should be increased to address this change. Indeed, the Taylor rule has been important in addressing some of the challenges which conventional inflation targeting cannot reach. However, the rule also has its own challenges and is often used together with other approaches in real economic situations (Prachowny, (2011). Microeconomics (Question a) It is certainly true that firms prefer making more profits to less. Profit is certainly a very important concept in the operations of a ...Download file to see next pagesRead More
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