Question: Consider two alternative policies, A & B, each with a different set of outcomes in terms of output and inflation as shown in the following

Consider two alternative policies, A & B, each with a different set of outcomes in terms of output and inflation as shown in the following table:

Year (t)

Output

Inflation Rate

Policy A

Policy B

Policy A

Policy B

1

1000

1020

2.0

2.0

2

1000

1030

2.5

2.0

3

950

1040

1.0

2.0

Potential output remains constant at 1000 from year 1 to year 3. The central banks loss function is where w =1, and the inflation target is 2%.

a. Calculate the value of the loss function over the three-year period for policies A and B. Which policy is preferred? (5 marks)

b. Would your answer be different from that in part a aboveif w = 5? Explain. (5 marks)

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