5. Inequity Aversion in a Simple Game: Consider the game illustrated in Figure 4

Question

5. Inequity Aversion in a Simple Game: Consider the game illustrated in Figure 4 (a) Suppose player 1 has not chosen the outcome A. Consider the following two games : A=(7, 100). B= (10.4),C=(5,5); 2 : A= (13,0), B= (10, 10),C=(5, 11) According to Fehr and Schmidt [1999], in which game is player 2 more likely to choose outcome B? Would this be supported in an experiment? (b) Suppose player 1 has not chosen the outcome A. Consider the following two games: T : A=(13,0). B=(10,4),C= (5,5) I2 : A-(7, 100), B (10, 10), C (5, 11) According to the Fehr-Schmidt model, in which game is player 2 more likely to choose outcome B ? Would this be supported in an experiment? (c) To what extent do these examples reflect a general problem with the Fehr-Schmidt model? Explain your answer.

Explanation / Answer

In this way, the exchange rate has become more volatile and its information content for

inflation has diminished to a large extent. The framework of monetary policy, in which

interest rates are adjusted in response to deviations of inflation from a targeted path, allows the

monetary authority to manage inflation expectations properly. For a small open economy, such

a policy shift is expected to strengthen the interest rate channel in a standard transmission

mechanism with a greater sensitivity of output and inflation dynamics to policy rates. The

following chapter discusses the increasing effectiveness of the policy instrument in Poland

Turkey during recent years.

The program succeeded not only in reducing the fragility of the economy thanks to the

measures aimed at restructuring the banking and public sectors, but also in alleviating

historically problematic issues such as inflation and country risk. This achievement has been

instrumental in bringing both inflation and real interest rates down to more reasonable levels.

Accordingly, economic agents started to reveal their inter temporal preferences in response to

changes in interest rates, and the link between real interest rates and spending decisions has

strengthened significantly.

By using time-varying parameter estimation methods, Kara et al (2007) find that the

effectiveness of the interest rates on the output gap, and the impact of the output gap on

inflation, have been increasing since the implementation of implicit inflation targeting

(Figure 2).

Furthermore, the magnitude of both parameters displayed an increasing trend during

the estimation period. To sum up, the transition to inflation targeting and the evidence of a

more responsive aggregate demand to real interest rates have emerged as remarkable

developments with respect to the improvement in the functioning of the interest rate channel

of transmission. Nevertheless, weakened fiscal dominance, reduced dollarization, and

improved interest rate pass-through have also been noteworthy determinants of the increased

effectiveness of short-term interest rates as a policy tool.

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