The policymaker's goal is to minimize the output gap and the future inflation rate.

• Assume β = 1 and rational expectations π e

• t+1 = Etπt+1. A central bank takes into account expectations when choosing its policy.
• Derive and interpret the FOC (central bank optimal targeting rule).
• We first minimize the objective function subject to the Philips Curve by substituting
• inflation in the objective function and then taking derivatives w.r.t. for xt
• The more persistent the inflation, the more aggressive the optimal policy response
• he Any inflation that is not addressed today persists into the future, potentially requiring further
output reductions. The persistence of inflation changes the output-inflation ratio
• less favorable: optimal policy requires more output for a given change in inflation
• contraction with adaptive expectations.
• 2. Consider the following version of the insider-outsider model (Romer). Profit of the firm