Fiscal and monetary policy lags â¢ Automatic stabilizers ...

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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
Page 1 and 2: CHAPTER 8POLICYChapter Outline:•
Page 3 and 4: policy runs the danger of failing i
Page 5 and 6: Having been exposed to a great numb
Page 7 and 8: • Students should be aware that t
Page 9: monetary growth rate should be incr
Page 13 and 14: monetary policy of the Fed over the
Page 15 and 16: the relative merits of the two appr
Page 17: expectations by following a monetar

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Fiscal and monetary policy lags â¢ Automatic stabilizers ...