9. Sensitivity of the Results to the Fed's Weight on Inflation
Equation 30, the interest rate reaction function, is estimated. It is an estimate of Fed behavior. The coefficient estimate on inflation in this equation is an estimate of how the Fed responds to inflation regarding its interest rate policy. The experiment in this chapter asks the question of how much different it would make regarding fiscal-policy effects if the inflation coefficient were larger.

We have seen in Chapter 5, Experiment 5.1, how the economy responds to a decrease in COG when the interest rate reaction function is used. We now examine the question of how the results change when the Fed's weight on inflation is larger. We will make the inflation coefficient in equation 30 three times as large as the estimated value and then rerun Experiment 5.1 for this version of the model.

Experiment 9.1: Experiment 5.1 with more weight on inflation in equation 30

  • Triple the third coefficient in equation 30. Solve the model for the forecast period. Call this dataset BASEA. Take BASEA as your base dataset, and change COG by -20 in each quarter of the forecast period. Solve the model for the forecast period. Call this dataset NEWA. Answer the following questions by comparing NEWA to BASEA.
  1. Note that a new base dataset had to be created because a coefficient was changed. The predictions of the new version of the model are not the same as the predictions in BASE, and so a new base dataset had to be created. It is not of interest to compare the predicted values in BASEA with the values in BASE. They differ, but only because a coefficient estimate has been arbitrarily changed. Make sure you understand what is going on here.
  2. Compare these results to those of Experiment 5.1. Explain carefully the differences. Do these differences make sense given that the Fed now cares more about inflation?

There are many other experiments of this type that you can perform. For example, you can change other coefficients in equation 30, say increasing the weight on unemployment, and examine how this affects the results of changing COG. You can also run different fiscal-policy experiments (other than just changing COG) once you have your new version of the model. Be sure each time you change a coefficient that you get a new base dataset (like BASEA above).