Fiscal and monetary policy lags • Automatic stabilizers ...

CHAPTER 8POLICYChapter Outline:• Fiscal and monetary policy lags• Automatic stabilizers• Uncertainties• Information feedback• Flexibility versus credibility• Rules versus discretion• Activist rules• Fine tuning• Policy instruments, indicators, and targets• Dynamic inconsistency• The independence of the central bankChanges from the Previous Edition:This used to be Chapter 18, starting with Section 18-4. Box 8-1 is new and deals with a monetarypolicy exercise. The paragraph dealing with the Lucas critique has been eliminated, since this nowcovered in Chapter 6. Sections 8-4 and 8-6 are also new. The first discusses monetary targets, indicators,and instruments and the second shows practical applications of targeting.Introduction to the Material:Policy makers consistently face the problem of how to respond to an economic disturbance.When contemplating economic stabilization policies, they have to deal with several major difficulties,including:• There is considerable uncertainty about the structure of the economy and the magnitude of aparticular policy response's effect.• The process by which policies affect the economy always entails some delays or lags.• It is not always clear whether a disturbance is transitory or persistent.• The outcome of any policy depends on people's (and firms') expectations and the private sector'sreactions to the policy, which are difficult to predict.• Policy makers must choose between sudden policy changes and gradual changes, and they needto decide whether they prefer flexibility or credibility in implementing their policy measures.The process by which policy actions affect the economy can be divided into two steps, the insidelag and the outside lag. The inside lag is the time period it takes to implement a policy action after aneconomic disturbance occurs. It is divided into three parts:104

• the recognition lag, which is the time period that it takes for policy makers to realize that adisturbance has occurred and that a policy response is warranted;• the decision lag, which is the time period it takes to decide on the most desirable policy responseafter a disturbance is recognized;• the action lag, which is the time it takes to actually implement the policy measure.Inside lags are shorter for monetary policy than for fiscal policy, since the FOMC meets on aregular basis to discuss and implement monetary policy. Fiscal policy, on the other hand, has to beinitiated and passed by both houses of the U.S. Congress and this can be a lengthy process.The outside lag is the time it takes for a policy action, once implemented, to have an effect on theeconomy. Generally, the outside lag is a distributed lag with a small immediate effect and a larger overalleffect over a longer time period. Outside lags are longer for monetary policy than for fiscal policy, sincemonetary policy actions affect short-term interest rates most directly, while aggregate demand dependsheavily on lagged values of income, interest rates, and other economic variables. A change in governmentspending, on the other hand, immediately affects aggregate demand.If a disturbance is transitory, it may be best not to respond at all, since the disturbance will mostlikely be over before the policy has an effect. It takes time to bring about change and, as a result,stabilization policy can actually be destabilizing. For small disturbances policy makers may fare best ifthey rely on automatic stabilizers, which automatically reduce the amount by which output changes as aresult of a disturbance. The inside lag of these automatic stabilizers is zero, which is desirable. On theother hand, these automatic stabilizers reduce the effectiveness of stabilization policies, which isundesirable when larger disturbances must be addressed.It is difficult but important to establish whether a disturbance is temporary or longer lasting, sinceaction is required if a disturbance appears to be persistent. After establishing the need for a policy action,policy makers must decide how fast they would like to achieve their desired policy objective. A coldturkey approach has the advantage of adding credibility to a specific announcement, whereas a gradualapproach allows for adjustments in moving towards the desired target as new information becomesavailable. Most economists agree that the Fed should use appropriate indicators to assess whether theavailable instruments have to be adjusted to achieve an ultimate target. The most appropriate instruments,indicators, and targets depend on the specific situation at hand.Section 8-6 discusses a series of possible targeting approaches, including real GDP targeting,nominal GDP targeting, and inflation targeting. Real GDP targeting is the best option for achieving fullemployment but is not effective in achieving price stability. By targeting nominal GDP, the central bankcreates a policy tradeoff between inflation and unemployment. By targeting inflation, the central bankloses its ability to respond to fluctuations in unemployment. Which targeting approach should be chosendepends greatly on one's belief of how steep or flat the Phillips curve is.Problems in conducting stabilization policy also arise from the difficulties in integratingexpectations into the macroeconomic models used to forecast the behavior of the economy. This isespecially important since the actions of policy makers affect the expectations on which the actions of theprivate sector are based. Failure to take these expectations (and reactions resulting from them) intoaccount is guaranteed to lead to inaccurate predictions of the effects of government policies. Policymakers know that their policy actions are much more effective if they have credibility. If policyannouncements are believed (and understood), then people will adjust to them much more rapidly. Butcredibility is only earned by consistent behavior over the long run, and is easily lost if policies change toofrequently.The public's reaction to a policy depends on expectations, so careful modeling of the public'sresponses to government policies is important. Otherwise successful stabilization policy is not feasible.Policy makers may consider a range of predictions about the effects of a policy measure, but any activist105

policy runs the danger of failing if the information available is poor. There is considerable uncertaintyabout how well economic models actually represent the workings of the economy. Furthermore, futureunanticipated shocks cannot be taken into account at the time a policy is implemented and this increasesthe danger of actually destabilizing the economy. The best approach to stabilization policy is probably touse caution and diversify with weaker doses of both fiscal and monetary policy. An overly ambitiouspolicy of trying to keep the economy at full-employment at all times (fine tuning the economy) bearsgreat risk, since a full-employment bias often leads to higher inflation.The debate over whether to pursue discretionary policy or follow a rule centers around thetradeoff between credibility and flexibility. While discretionary policy has the advantage of giving policymakers the flexibility to react to disturbances, policy rules allow for more certainty about futuregovernment actions and thus create more rational expectations among the private sector in anticipatingpolicy measures. If policy rules are clearly established and followed, then policy makers can, on occasion,respond more effectively to a large disturbance without losing credibility.It should be noted that it is possible to design activist monetary policy rules. Equation (8), whichlinks changes in monetary growth to changes in the unemployment rate, serves as an example for such anactive monetary policy rule. But even if a policy rule has been established, it must be clear who has theauthority to change the rule if necessary. Policy makers also have to decide whether they shouldannounce in advance what policies they will follow. Such announcements can be more harmful thanhelpful in cases where the announced targets are abandoned. In such cases, policy makers lose theirreputation for displaying consistent behavior.The problem of dynamic inconsistency, that is, the fact that policy makers often are tempted totake short-run actions that will impede their long-run goals, should also be considered. Clearly a goal offull employment with little or no inflation is desirable. However, because of the short-run tradeoffbetween unemployment and inflation, it is not possible to immediately lower inflation and unemploymentsimultaneously. Therefore, when anti-inflationary policies are implemented and the unemployment raterises, politicians are often tempted to address the unemployment problem. However, such action willimpede their anti-inflation policy. One way around this problem is to establish a truly independent centralbank with a clear mandate to fight inflation. Countries with independent central banks tend to have loweraverage inflation rates.Suggestions for Lecturing:The purpose of stabilization policies is to counteract economic disturbances that may arise fromchanges in private or public spending, wars, technological innovations, changes in supply conditions, or awide range of other occurrences. But policy makers themselves may just as well cause disturbances. Ifpolicy measures are based on short-term political goals or simply on poor information, they may actuallydestabilize the economy.Policy makers face a variety of problems that should be pointed out to students. For one, it is notalways clear whether disturbances are temporary or persistent. If a disturbance is only temporary, then thegovernment may be better off not taking any action at all. It not only takes a fair amount of time todevelop and enact an appropriate policy response, but it also may take a considerable amount of time for apolicy measure to have the desired effect on the economy. Part of the effect of any disturbance is offset byautomatic stabilizers (the income tax system, unemployment insurance, the Social Security system, etc.),which do not have any inside lags. As active policy responses to small disturbances are likely to bedestabilizing, it is better to rely on such automatic stabilizers to fine tune the economy. However,automatic stabilizers are insufficient for more severe economic disturbances. Larger and more persistentdisturbances require appropriate policy actions, in spite of the difficulties that taking action may pose.106

Unfortunately, the automatic stabilizers reduce the size of the fiscal policy multiplier and therefore theeffectiveness of fiscal stabilization policies. Chapter 9 mathematically derives the government spendingmultiplier, and instructors may want to postpone a more in-depth discussion of how the fiscal policymultiplier is affected by automatic stabilizers until later.Instructors should clearly point out the distinction between inside and outside lags. Inside lagstend to be discrete, that is, of a specified length, whereas outside lags are distributed over time. The insidelag, which is a combination of the recognition, decision, and action lags, is much longer for fiscal policythan for monetary policy. Fiscal policy has to be initiated and passed by both houses of Congress, whichcan be a lengthy process, as can be seen in the ongoing debate on tax reform or any Social Securityreform. Monetary policy can be implemented much more quickly since the FOMC meets on a regularbasis to discuss and decide on monetary policy actions. On the other hand, the outside lag, which isgenerally a distributed lag, which takes account of the effects of a policy action over time, is much shorterfor fiscal policy than for monetary policy. A change in government spending affects aggregate demandimmediately, leading to a further series of induced changes in output and spending. But monetary policyactions must first change short-term interest rates, then long-term interest rates, and then the level ofinvestment spending before its full effects are felt.The reluctance of the government to make hard choices reflects the difficulties encountered inachieving successful discretionary fiscal policy. On the other hand, the successful record of thediscretionary monetary policy approach taken by the Fed for most of the past two decades appears toindicate that an activist monetary policy can be effective.Based on the argument that the lags for monetary policy are long and variable and that ourknowledge of the workings of the economy is fairly limited, some economists favor some form of amonetary growth rule. They argue that a strict monetary growth rule with announced targets wouldgreatly reduce the uncertainty the private sector faces when forming inflationary expectations. Noteveryone agrees with this assessment, however, and the discussion of whether to follow a rule or topursue discretionary policy centers around the tradeoff between credibility and flexibility. Whilediscretionary policy has the advantage of giving policy makers the flexibility to react to disturbances,policy rules allow for more certainty about future policy actions. This creates more rational expectationsin the private sector and a quicker return to full employment. In addition, these rules reduce all kinds ofpolitical pressure. It should be noted that policy makers have a hard time earning credibility and thatcredibility is easily lost if policies are changed frequently.In the debate over rules versus discretion, it is important to note that policy rules do not have tobe passive. An active monetary policy rule is represented in Equation (8), which suggests that the moneysupply growth rate should be increased by two percent for every one percent increase in theunemployment rate over the natural rate. In this case, an anticyclical monetary policy is achieved withoutdiscretion, allowing the public to anticipate the government's action.Government policies affect private sector expectations and actions. But at the same time, privatesector expectations and actions affect the success of government policies. The government must beconsistent enough in its policy decisions to enable the private sector to anticipate fairly accurately whatthe government will do in a particular situation. If policy actions can be correctly anticipated, markets willclear more quickly, and stabilization policy will be much more effective.Econometric models, which consist of a set of equations that are based on past economic behavior,are generally used to forecast the effects of various policy options. It is important to emphasize that suchmodels come in all shapes and sizes. One cannot generalize that the more comprehensive models alwaysproduce better forecasts. No model is a perfect image of the economy and we still do not really know howthe economy works. Therefore we should view forecasts only as best guesses, based on incompleteinformation and subject to modifications as unexpected events take place.107

Having been exposed to a great number of graphs in their economics classes, students oftenpicture government economists in Washington looking at similar graphs and trying to determine whichcurve has shifted to cause a disturbance. Students may not be aware that these economists think in termsof statistical data presented in tables or obtained through regression analysis. It is therefore important to atleast briefly discuss how econometric models work. It is an even better idea to have students collect dataon some economic variables on their own, and require them to interpret their importance or therelationships among them. The following question can then be posed: Do the simple graphicalframeworks used in class provide an adequate tool for forecasting? In many cases, students may agreethat, while these graphs cannot show the magnitude of a change, they do at least show the directioncertain key variables are expected to take after a disturbance has occurred.Policy makers have to make decisions under a great deal of uncertainty. First, they do not knowhow well the forecasting model they use reflects the economy. Second, they never know how the publicwill respond to particular policies and thus cannot be sure of the magnitude of the impact that policyactions will have. Therefore it is always best to proceed cautiously. But in reality policy makers tend to beoverly ambitious and often create problems for themselves. Politicians who have lots of discretion areeasily tempted to implement policies that address short-run concerns even though these actions maythreaten a desired long-term goal. This is known as dynamic inconsistency.The following example may highlight this concept vividly in students' minds. Assume you are thepresident of your country and you have to deal with an extremist group. They have taken hostages andhave threatened to kill them unless their demand to free one of their members (who is incarcerated forhaving committed a violent crime) from prison is fulfilled. Will you give in to these demands? Your longtermgoal is to establish the fact that the government cannot be held hostage to unreasonable demands.Otherwise extremists are likely to take further hostages so they can make further demands. However, ifthe hostages are killed, then you will be blamed for it. This may not only disturb your good consciencebut also threaten your upcoming re-election. Chances are, you will make a deal and hope that you willfind a way to deal with the extremists before they strike again.Obviously, this example does not deal with fiscal or monetary policy responses to a disturbance.However, it highlights the dilemma that policy makers have to face constantly: Should we stick to apreviously established objective or should we adjust our actions as circumstances warrant? Similarly, ithighlights the trade-off between the desire for credibility or flexibility.One way around the problem of dynamic inconsistency is to impose strict rules. Another is toestablish a central bank that has a clear mandate to keep inflation low and is largely independent frompolitical pressures by the administration. Empirical evidence shows that countries with independentcentral banks consistently have lower inflation rates.Chapter 8 discusses the use of instruments, indicators, and targets as well as three differenttargeting approaches: real GDP targeting, nominal GDP targeting, and inflation targeting. This discussionreinforces how different views of the shape of the Phillips curve can determine the policy approach that ischosen by government decision makers. However, as these issues are discussed again in Chapter 16 inconjunction with the way the Fed operates, some instructors may want to postpone an in-depth discussionof the use of the appropriate instruments, indicators, and targets until later.Additional Readings:Bernanke, et. al., "Missing the Mark: The Truth about Inflation Targeting," Foreign Affairs,September/October, 1999.Bernanke, B. and Mishkin, F., “Inflation Targeting: A New Framework for Monetary Policy?” Journal ofEconomic Perspectives, Spring, 1997.108

Blinder, Alan, "Central Banking in a Democracy," Economic Quarterly, FRB of Atlanta, Fall, 1996.Cechetti, Stephen, “Policy Rules and Targets: Framing the Central Banker’s Problem,” Economic PolicyReview, FRB of New York, June, 1998.Clarida, Richard, et. Al., “The Science of Monetary Policy: A New Keynesian Perspective,” Journal ofEconomic Literature, December, 1999.Clark, Todd, "Nominal GDP Targeting Rules: Can They Stabilize the Economy?" Economic Review, FRBof Kansas City, Third Quarter, 1994.Cogley, Timothy, "Why Central Bank Independence Helps to Mitigate Inflationary Bias," EconomicLetter,FRB of San Francisco, May, 1997.Diebold, Francis, “The Past, Present, and Future of Macroeconomic Forecasting,” Journal of EconomicPerspectives, Spring, 1998.Dittmar R. and Gavin, W., ”What Do New-Keynesian Phillips Curves Imply for Price-Level Targeting?”Review, FRB of St. Louis, March/April, 2000.Fischer, Stanley, "Why Are Central Banks Pursuing Long-Run Price Stability?" in Achieving PriceStability,FRB of Kansas City, 1996.Friedman, Benjamin, "Targets, Instruments, and Indicators of Monetary Policy," Journal of MonetaryEconomics, October, 1975.Havrileski, Thomas, "Electoral Cycles in Economic Policy," Challenge, July/August, 1988.Heller, Walter, "Activist Government: Key to Growth," Challenge, March/April, 1986.Koenig, Evan, “Is the Fed Slave to a Defunct Economist?” Southwest Economy, FRB of Dallas,September/October, 1997King, R. and Wolma, A., "Inflation Targeting in a St. Louis Model of the 21 st Century," Review, FRB ofSt. Louis, May/June, 1996.Melzer, Thomas, “Credible Monetary Policy to Sustain Growth,” Review, FRB of St. Louis,July/ August, 1997.McNees, Stephen, "An Assessment of the 'Official' Economic Forecasts," New England Economic Review,July/August, 1995.McNees, Stephen, "How Large Are Economic Forecast Errors?" New England Economic Review,July/August, 1992.Poole, William, "Monetary Policy Rules?" Review, FRB of St. Louis, March/April, 1999.Poole, William, "A Policy Maker Confronts Uncertainty," Review, FRB of St. Louis, September/October,1998.Rudebusch, Glenn, "Is Opportunistic Monetary Policy Credible?" Economic Letter, FRB of San Francisco,October 4, 1996.Stark, T., and Taylor, H., "Activist Monetary Policy for Good or Evil? The New Keynesians vs. the NewClassicals," Business Review, FRB of Philadelphia, March/April, 1991.Svensson, Lars, “Price Level Targeting vs. Inflation Targeting: A Free Lunch?” Journal of Money, Credit,and Banking, August, 1999.Learning Objectives:• Students should be able to define inside and outside lags and explain their importance in assessingactive stabilization policies.• Students should understand the concept of automatic stabilizers.109

• Students should be aware that the workings of the economy are still not completely understood, andthat many questions remain unanswered, including how expectations are formed and what the basesfor the private sector's reactions to policy measures are.• Students should be aware that poor information and uncertainty about the accuracy of economicmodels may lead to policy measures that are ineffective or even destabilizing.• Students should know the pitfalls of a cold turkey approach versus a gradualist approach.• Students should be familiar with the instruments, indicators, and targets of monetary policy.• Students should be aware of the difference between real GDP targeting, nominal GDP targeting, andinflation targeting.• Students should be aware that the “rules versus discretion” approach often implies a tradeoff betweenflexibility and credibility and should be able to discuss the merits of each policy approach.• Students should understand the concept of dynamic inconsistency.• Students should be able to discuss the desirability of an independent central bank.Conceptual Problems:Solutions to the Problems in the Textbook:1. The first question you should ask yourself as a policy maker is whether a disturbance is transitory orpersistent. You should then ask yourself how long it would take to put a suggested policy measureinto effect and how long it will take for the policy to have the desired effect on the economy. Inaddition, you need to know how reliable the estimates of your advisors are about the effects of thepolicy. If a disturbance is small and probably transitory, you may be best advised to do nothing,because any measure you take is likely to have its effect after the economy has recovered. Thereforeyour action might only further aggravate the problem.2.a. The inside lag is the time it takes after an economic disturbance has occurred to recognize andimplement a policy action that will address the disturbance.2.b. The inside lag is divided into three parts. First, there is the recognition lag, that is, the time it takes forpolicy makers to realize that a disturbance has occurred and that a policy response is warranted.Second, there is the decision lag, that is, the time it takes to decide on the most desirable policyresponse after a disturbance is recognized. Finally, there is the action lag, that is, the time it takes toactually implement the policy measure.2.c. Inside lags are shorter for monetary policy than for fiscal policy since the FOMC meets on a regularbasis to discuss and implement monetary policy. Fiscal policy, on the other hand, has to be initiatedand passed by both houses of the U.S. Congress and this can be a lengthy process. The exceptions arethe so-called automatic stabilizers; however, they only work well for small and transitorydisturbances2.d Automatic stabilizers have no inside lag; they are endogenous and function without specificgovernment intervention. Examples are the income tax system, the welfare system, unemploymentinsurance, and the Social Security system. They all reduce the amount by which output changes inresponse to an economic disturbance.110

3.a. The outside lag is the time it takes for a policy action, once implemented, to have its full effect on theeconomy.3.b. Generally, the outside lag is a distributed lag with a small immediate effect and a larger overall effectover a longer time period. The effect is spread over time, since aggregate demand responds to anypolicy change only slowly and with a lag.3.c. Outside lags are longer for monetary policy since monetary policy actions affect short-term interestrates most directly, while aggregate demand depends heavily on lagged values of income, interestrates, and other economic variables. A change in government spending, however, immediately affectsaggregate demand.4. Fiscal policy has smaller outside lags, but significant inside lags. Monetary policy, on the other handhas smaller inside lags and longer outside lags. Therefore large open market operations should beundertaken to get an immediate effect, but they should be partially reversed over time to avoid a largelong-run effect. If the shock is sufficiently transitory and small, policy makers may be best advisednot to undertake any policy change at all.5.a. An econometric model is a statistical description of all or part of the economy. It consists of a set ofequations that are based on past economic behavior.5.b. Econometric models are generally used to forecast the behavior of the economy and the effects ofalternative policy measures.5.c. There is considerable uncertainty about how well econometric models actually represent the workingsof the economy. There is also great uncertainty about the expectations of firms and consumers andtheir reactions to policy changes. Any policy is bound to fail if the information on which it was basedis poor.6. The answer to this question is student specific. The main difficulties of stabilization policy arise fromthree sources. First, policy always works with lags. Second, the outcome of any policy depends on theway the private sector forms expectations and how those expectations affect the public's behavior.Third, there is considerable uncertainty about the structure of the economy and the shocks that hit it.It can be argued that a monetary policy rule would greatly reduce uncertainty about the Fed'spolicy responses. If the government behaved in a consistent way, then the private sector would alsobehave more consistently and economic fluctuations could be greatly reduced. A monetary growthrule would also reduce any political pressure the administration might exert on the Fed. It is ofteninitially unclear whether a disturbance is temporary or persistent and a monetary policy rule wouldprevent policy mistakes in cases where the disturbance is, in fact, temporary. If active monetarypolicy is applied to a temporary disturbance, then the lags involved will guarantee that the economywill actually be destabilized.On the other hand, the workings of the economy are not completely understood and events cannotalways be predicted. Thus it is difficult to argue for a fixed policy rule. Unanticipated largedisturbances warrant an activist policy, especially if they appear to be persistent. It is also possible toconstruct a more activist monetary growth rule. For example, Equation (8) suggests that the annual111

monetary growth rate should be increased by two percent for every one percent that unemploymentincreases above its natural rate. Such a rule is based on the quantity theory of money equation (whichrelates money supply growth to the growth of nominal GDP) and on Okun's law (which relates theunemployment rate to economic growth). Obviously, because of the long lags for monetary policy,any monetary growth rule will work much better in the long run than in the short run.Fiscal policy rules may make more sense than monetary policy rules, since fiscal policy has longinside lags but shorter outside lags. In a way, built-in stabilizers, although generally not considered"rules", already provide some stability without any inside lag. Many of the arguments againstmonetary policy rules are also valid for fiscal policy rules and many economists oppose them. Thefrequently proposed constitutional amendment requiring an annually balanced budget is an exampleof a fiscal policy rule. There are significant problems associated with such an amendment, since itwould greatly limit the government's ability to undertake active fiscal stabilization policy.7. The arguments for a constant growth rate rule for money are based on the quantity theory of moneyequation, that is,MV = PY.From this equation we can derive%∆P = %∆M - %∆Y + %∆V.If the long-run trend rate of real output (Y) and the long-run trend of velocity (V) are assumed to befairly stable, and if wages and prices are sufficiently flexible, then a constant monetary growth rate(M) would insure a constant rate of inflation, that is, a constant rate of change in the price level (P).Also, since monetary policy has long outside lags, active monetary policy can actually be moredestabilizing than stabilizing. In addition, since we do not know exactly how the economy works ormay react to specific policies, it is best to follow a rule rather than undertake actions that haveuncertain outcomes. However, rules are not without problems, as they would not allow flexibility inresponding to major disturbances.8. Dynamic inconsistency occurs if, after having committed themselves to a specific policy actiondesigned to achieve a long-run objective, policy makers find themselves in a situation where it seemsadvantageous to abandon their original policy, in order to achieve a short-run goal. Such action willimpede the long-run objective.9. Real GDP targeting is the best option if the primary policy goal of monetary policy is to achieve fullemployment. If policy makers forecast potential GDP correctly, then full employment combined withlow inflation can be achieved. However, real GDP targeting bears the greater risk that the secondarygoal of achieving a low inflation rate will be missed. If the rate at which potential GDP grows isoverestimated, then policy makers may stimulate the economy too much. In this case, they will not besuccessful in achieving price stability. By targeting nominal GDP, the central bank creates a policytradeoff between inflation and unemployment. If the rate at which potential GDP grows isoverestimated and policy makers stimulate the economy too much, we will get less growth but also112

less inflation than under real GDP targeting. Which targeting approach should be chosen dependsgreatly on how steep or flat the Phillips curve is perceived to be.Technical Problems:1. If actual GDP is expected to be $40 billion below the full-employment level and the size of thegovernment spending multiplier is 2, then government spending should be increased by $20 billionover its current level. For the next period, when actual GDP is expected to be $20 billion belowpotential, government spending should be cut by $10 billion from its new level, that is, to $10 billionover its original level. In period three, when actual GDP is expected to be at its full-employment level,the level of government spending should again be cut by $10 billion from the last period's level tobring it back to the original level of Period 0.2.a. If there is a one-period outside lag for government spending, then nothing can be done to close thecurrent GDP-gap. The government should decide to spend $10 billion more for the next period andreduce spending again to its original level after that.2.b. Graph I below shows the path of GDP for Problem 1 with no outside lag and Graph II shows the pathof GDP for problem 2.a. with a one-period outside lag. In each of the graphs the path of actual GDP isshown, first assuming that no policy action takes place and then assuming that the policies proposedin Problems 1 and 2.a. are undertaken.GDPGraph IGDPpotential GDPpotential GDP0 time 0 timeGDP with fiscal policyGDP without fiscal policyGraph IIGDPpotential GDPGDPpotential GDP0 time 0 timeGDP with fiscal policyGDP without fiscal policy113

3.a. Since the government multiplier for the first period is 1, the level of government spending must beincreased by ∆G = $40 billion to close the GDP-gap of $40 billion. But since the governmentmultiplier in the next period for the amount spent in this period is 1.5, the effect of an increase ingovernment spending in the first period by $40 billion would be an increase in GDP by $60 billion inthe second period.3.b. For the second period a GDP-gap of $20 billion is expected. However, as we saw in 3.a., GDP willincrease by $60 billion in the second period if the government increases spending by $40 billion inthe first period. Therefore, the government has to reduce spending in the second period by $40 billionfrom its new level (back to its original level), since the multiplier for a spending change in the sameperiod is 1.3.c. In this problem, fiscal policy has an outside lag. This means that the effect of an increase ingovernment spending is felt both in the period in which the spending increase takes place and (to aneven larger degree) in the following period. The increase in government spending needed to close theGDP-gap in the first period is guaranteed to overshoot the desired goal in the next period. Thus thegovernment will be forced to reverse its increase in spending to the original level in the second periodto offset the destabilizing effect. In a case like this, the government has to be much more active in itsfiscal policy than in a situation where no distributed lag exists.4. If there is uncertainty about the size of the multiplier, then fiscal policy becomes much morecomplicated. If the multiplier is 1, then an increase in government spending by $40 billion will closethe GDP-gap in the first period. If the multiplier is 2.5, we will overshoot potential GDP by $60billion. An increase in spending by 40/2.5 = $16 billion is optimal if the multiplier is 2.5. Thus acautious government will probably increase spending by no more than $16 billion in the first period,and then reduce the level of spending by $8 billion in the next period ($8 billion above the originallevel). Such a policy action is designed to close the GDP-gap to some degree over the first twoperiods while never overshooting potential GDP. In Period 3 we will again be back at the fullemploymentlevel. The extent to which a less cautious government might exceed these suggestedspending increases depends largely on that government's level of concern about unemployment versusinflation.5. To follow an established rule for its policy, the Fed needs to know the source of each disturbance. If adisturbance comes from the goods sector, it is better to have a monetary growth target; if thedisturbance comes from the money sector, it is better to have an interest rate target.a. Assume a disturbance comes from the money sector. If an increase in money demand increases theinterest rate, the Fed should try to maintain a constant interest rate by increasing the supply of money.This will re-establish the old equilibrium values of the interest rate and output and effectively offsetthe disturbance.b. Assume a disturbance comes from the goods sector. If an increase in autonomous investmentincreases the interest rate, then it is not advisable to maintain a constant interest rate. Trying to lowerthe interest rate again by increasing the money supply would aggravate the disturbance. On the otherhand, maintaining a constant money supply, while not offsetting the disturbance, will at least notmake things worse.114

6.a. Students will have to check the Federal Reserve Bulletin in early 2000 and compare the forecasts ofthe Federal Reserve Board with the actual performance of the economy in 1999.6.b. Regardless of how detailed it is, no econometric model can accurately represent the economy, sincewe do not completely understand the way the economy works. Therefore, we can never expect perfectforecasts. It is impossible to incorporate all the relevant information on which individuals and firmsbase their expectations about the future and to determine how these expectations affect actions in anygiven situation. Forecasts are generally based on the information available at the time, which may beflawed or outdated. In addition, any unexpected change, such as a supply shock, an unanticipatedinternational change, or an unanticipated domestic policy change, can render the initial predictionswrong.Additional Problems:1. Define and distinguish between inside and outside lags.The inside lag is the time period it takes to implement a policy action after an economic disturbance isrecognized. It is divided into the recognition lag (the time it takes for policy makers to realize that adisturbance has occurred and that a policy response is warranted), the decision lag (the time it takes todecide on the most desirable policy response), and the action lag (the time it takes to implement the policymeasure). The outside lag is the time it takes for a policy measure, once implemented, to have an effect onthe economy.2. How do long lags in investment spending affect the usefulness of a government policy that triesto stabilize the economy via investment tax credits?Long lags in investment spending suggest that investment tax credits should not be used for fine-tuningbut may be useful in responding to a prolonged disturbance. However, the lag is much shorter fortemporary investment tax credits, which often speed up existing or planned investments. Thereforeinvestment tax credits can be used for short-run stabilization, even though uncertainty about theirfrequency and duration may create unstable swings in investment spending.3. "Monetary policy should be employed only sparingly since it operates with long and variablelags." Comment on this statement.There are lags both in recognizing that there is a need for a policy response to a disturbance and indesigning a particular policy measure. Once the program is in place, it takes additional time to affecteconomic activity. For example, expansionary monetary policy lowers short-term interest rates and then,after a lag, also lowers long-term interest rates, which, in turn, increases investment spending. Beforecommitting themselves to increased investment spending, firms need to determine whether the cost ofcapital has risen temporarily or permanently. Ultimately, aggregate demand is affected and then a seriesof induced adjustments in output and spending will take place. Therefore, while the inside lags formonetary policy actions are short, it takes time for monetary policy to affect aggregate demand to thedesired degree since there is an additional distributed lag (the dynamic multiplier process). If monetarypolicy is employed, it should be done with caution, since it can be destabilizing. But the fairly successful115

monetary policy of the Fed over the last two decades indicates that it is possible to undertake activemonetary policy without destabilizing the economy.4. "Monetary stabilization policy is difficult for the Fed because of the existence of long andvariable outside lags. But if the Fed knew the exact length of these lags, active monetarystabilization policy would always be successful." Comment on this statement.If lags are long and variable, it becomes very difficult to predict exactly when a certain policy measure isgoing to have its desired effect on the economy. It is thus difficult to successfully implement countercyclicalstabilization policies. If the timing of a policy measure is misjudged, the economy may actuallybe destabilized rather than stabilized. If lags were long but fixed, it would be much easier to judge whento implement a policy measure. However, this is unrealistic since there is still considerable uncertaintyabout the workings of the economy and about the accuracy of the theoretical models used in forecasting.5. Is the fact that economists often put decimal points in their forecasts an indication that they canbe very accurate in their predictions? Why or why not?The econometric models from which economic forecasts are derived are based on the historical record ofthe economy. However, not every disturbance can be predicted with accuracy. An economic forecastrepresents only a best estimate of how the economy will behave based on (often incomplete) informationand a set of initial assumptions. A forecast of 1.5% real economic growth should be interpreted as growthanywhere in the range of 1 to 2 percent.6. True or false? Why?"The Fed can always maintain full employment if it uses its policy instruments appropriately."False. Monetary policy works with long and variable outside lags. Furthermore, by the time the Fed hasidentified the source and duration of an economic disturbance and decided on the appropriate response,the shock will already have done some damage. Fine tuning the economy through the use of monetarypolicy is impossible.7. True or false? Why?"Announcing a policy may be just as effective as actually implementing it."False. There may be short-run effects of policy announcements if individuals act in anticipation of theannounced change. Such announcements in and of themselves, however, do not have lasting implicationsfor economic activity unless the government consistently follows through with the proposed policy.Indeed, making announcements and then not following through threatens the credibility and reputation ofpolicy makers and may ultimately render policy announcements destabilizing.8. "Policy makers committed to full employment encounter major problems if they underestimatethe natural unemployment rate." Comment on this statement.116

Policy makers, who assume that the natural rate of unemployment is 4% rather than its actual 5.5%, willtry to stimulate the economy through expansionary policies as soon as the rate of unemployment goesabove 4%. But this will decrease unemployment only temporarily since the economy has a tendency to goback to the true natural rate. To maintain the 4% level, policy makers will have to stimulate the economyagain and again which will, in turn, create inflationary pressure. Since inflation reduces real wages,workers will ask for wage increases and we will enter the so-called wage-price spiral.9. Briefly discuss the arguments for and against fine tuning the economy.Fine tuning the economy involves the use of policy tools to counteract every disturbance in the economy,even small ones. Since there are lags in stabilization policies and considerable uncertainty about whethera disturbance is temporary or permanent, a very active stabilization policy in the face of very smalldisturbances may actually be destabilizing. If a decision to fine tune is made, minimal initial policyresponses to economic disturbances are advised, especially if there is uncertainty about the size of thefiscal or monetary policy multiplier.10. What are the relative merits of a cold turkey over a gradualist approach to fight inflation? Inyour answer discuss the concept of time inconsistency and the importance of credibility.The key question for governments desiring to reduce inflation is how cheaply (in terms of lost output)they can achieve a desired inflation rate. A gradual strategy attempts a slow and steady return to lowinflation by reducing monetary growth slowly in an attempt to avoid a significant increase inunemployment. This approach takes a lot longer than the cold-turkey approach that attempts to reduceinflation quickly by immediately and sharply reducing monetary growth. The central question here is howflexible wages and prices are and how fast expectations adjust. With a cold turkey approach, inflation andinflationary expectations will be reduced faster. An increase in the level of unemployment leading to adecrease in the level of output will result in the short run in either case, but the economy will eventuallyadjust back to the full-employment level of output.The term time inconsistency refers to the problem that the Fed faces when a policy may lookappropriate at the time it is announced, but when it is time to execute it, it may no longer look desirable. Ifthe Fed consistently tries to keep inflation under control, even though it may cause some unemploymentin the short run, the public will keep inflationary expectations low and is more likely to adjust wagedemands downwards. Credibility makes it easier for the Fed to conduct its policies, since the publicknows what to expect and will react predictably. For example, if the Fed were to follow a monetarygrowth rule, then people could more easily anticipate the effects of a disturbance and adjust to it. But ifthe Fed had a reputation of changing its monetary policy often and unpredictably, its policies might nothave the desired effects, since people might not react in the desired way.11. "A cold-turkey approach is better than a gradualist approach for fighting inflation, since itrequires a shorter time to establish a long-run equilibrium at a desired lower inflationrate." Comment on this statement.The gradualist approach lowers money growth over a long period of time to minimize the severity of anyresulting recession. The cold-turkey approach achieves the reduction in the inflation rate more quickly,but at the cost of a significant increase in short-run unemployment. Normative considerations determine117

the relative merits of the two approaches. The cold-turkey approach may benefit from a credibility bonus,since workers and firms do not have to guess whether the government is really committed to lowering theinflation rate. They may therefore reduce their inflationary expectations faster and the economy willadjust back to full-employment much faster. However, if long-term contracts exist, wages and pricescannot adjust quickly and a rapid return to a low-inflation equilibrium at full-employment is fairlyunlikely.12. Comment on the following statement:“Achieving a zero inflation rate by imposing a monetary growth rule will result in moreeconomic stability, a higher growth rate, and a better income distribution.”According to the equation (%∆P) = (%∆M) - (%∆Y) + (%∆V), a zero inflation rate (%∆P) can be easilyachieved if monetary growth (%∆M) is kept at a rate equal to the long-term growth rate of real income(%∆Y) adjusted for velocity (%∆V). A monetary growth rule works well if the economy is inherentlystable, if most disturbances are small and of short duration, and if velocity is fairly stable or at leastpredictable. But such a monetary growth rule would tie the central bank's hands if a large disturbanceoccurred. The cost of long and high unemployment can be very high, especially if wages and prices arefairly rigid. Periods of high and long unemployment particularly affect low-income workers with lowskills and therefore the income distribution worsens. While some economists contend that low inflationcountries have a higher average economic growth rate, there is no good evidence available for thisassertion.13. Would you support a monetary growth rule that maintains the rate of money supply at 3%,which is slightly higher than the long-term trend of potential output? Why or why not? Explainyour answer.The answer to this question is student specific. A student who believes that the economy and velocity arevery stable and that disturbances are fairly transitory will probably support such a rule. The argument forsuch a rule is that it may create more rational expectations in the private sector regarding policy actionsby the Fed. Thus, after a disturbance, the private sector would adjust more rapidly and the economywould go back to full employment much more quickly.A student, who believes that disturbances may be persistent, that wages and prices do not adjustrapidly, and that long periods of unemployment are costly, would advocate a more activist approach. Thisis especially true if velocity is not very stable.Recent experience indicates that a discretionary approach promises more success in keeping theeconomy close to full employment without causing unacceptable inflation.14. "Credibility is extremely important in the conduct of monetary policy." Comment on thisstatement and relate your answer to the concept of dynamic inconsistency.Assume there is a supply shock and the Fed has to decide whether to keep unemployment low byimplementing expansionary monetary policy or to concentrate on keeping inflation under control. Thedynamic inconsistency approach suggests that the Fed should refrain from a policy response that maylook appropriate in the short run but will prove unproductive in the long run. If the Fed always chooses toaccommodate a supply shock, people will come to expect such a reaction and will incorporate the118

assumption of a higher inflation rate in their wage demands. But if the Fed consistently tries to keepinflation under control (even though it may cause some unemployment in the short run), people will lowertheir inflationary expectations. The Fed will keep its reputation as an inflation fighter, and the economywill adjust back to full employment fairly rapidly.15. "Policy rules are always preferable to discretionary policy." Briefly comment on this statement.Policy rules predetermine the actions of policy makers and thus eliminate the uncertainty of governmentactions. This may reduce some of the instability that arises from mistaken expectations. Unfortunately,however, rules do not allow enough flexibility to respond to unforeseen events and cannot accommodatethe range of policies required to reduce large and prolonged disturbances.16. Explain why it is important for the Fed to have credibility in its effort to maintain pricestability.Credibility is very important for the Fed, since consistent government actions lead to more accurateprivate sector expectations. For example, if the Fed were to follow a monetary growth rule, then peoplecould more easily anticipate the effects of a disturbance and could adjust to it. If the Fed consistently triesto keep inflation under control, even though it may cause some unemployment in the short run, peoplekeep their inflationary expectations low and adjust their wage demands downwards. But if the Fed has areputation of changing its monetary policy often and unpredictably, its policies may not have the desiredeffects, since people may not react in the desired way. As a result, active monetary policy may actually bedestabilizing.17. "A monetary policy rule is preferable to discretionary stabilization policy." Comment on thisstatement. In your answer discuss the arguments for and against fine tuning the economy.Policy rules make the actions of policy makers predictable and thus eliminate the uncertainty that comesfrom unanticipated government actions. They also may reduce instability arising from mistakenexpectations. However, rules do not allow flexibility in responding to unforeseen large and prolongeddisturbances. Only a very strong proponent of monetarism or the rational expectations approach wouldpropose a strict monetary growth rule.Fine tuning the economy involves the use of policy tools for all (even small) disturbances. But sincethere are always policy lags and uncertainty about the length of disturbances, fine-tuning may actually bedestabilizing. Therefore small policy responses should be undertaken initially and revised later, as moreinformation about the true nature of the disturbance becomes available.18. "The economy always adjusts back to the full-employment level of output, so policy makersshould not be concerned with undertaking active stabilization policy. Instead they shouldestablish more credibility by following a well-defined policy rule." Comment on this statement.Since wages are flexible in the long run, the economy will always eventually adjust back to fullemployment. According to the Phillips-curve analysis, the economy will be at full employment as long asexpected inflation is equal to actual inflation. Therefore, policy makers can create more rational119

expectations by following a monetary growth rule and announcing its monetary growth targets in advance.In this case, money illusion will not exist and any announced reduction in the growth rate of moneysupply will lead to lower inflation without much increase in unemployment. But if there is no such ruleand the Fed has a reputation of changing its monetary policy often, policies may not have the desiredeffects, since people may not react in the desired way.It should be noted that an activist monetary growth rule can be designed in which money supplygrowth changes with changes in the unemployment rate. Fiscal policy rules can also be designed (such asa balanced budget amendment, for example). Whether policy rules actually make sense depends on howfast the economy adjusts back to full employment and how flexible wages and prices are. In the case oflarge disturbances, rules limit the flexibility of policy makers to respond to a disturbance that may resultin a high rate of unemployment. Finally, there are the questions of whether policy rules should beannounced in advance and who has the authority to change them if necessary. Finally, if disturbances areperceived to be small it may be better to rely on automatic stabilizers.120