Question

1. Answer the following two questions:
   1. Discuss the main assumptions and principles of the inflation targeting monetary policy regime.
   2. Consider the following Central Bank (CB)’s loss function: ?? = (?? − ?? )² +

?(?? − ?^?)², where, in addition to the variables previously defined in (2), ?^? is the inflation target and ? is a sensitivity parameter. Answer the following two questions:

1. Assume that ? = 1, ? > 1 and ? < 1. Discuss the implications for the CB’s loss function for each value of ?; and represent graphically the respective loss functions.
2. Derive the Monetary Rule for an inflation targeting CB: ?? − ?? =

−??(?? − ?^?); and discuss the main assumptions used to derive it.

Answer 1