Fiscal and monetary policy lags • Automatic stabilizers ...

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 Forecasts are generally based on the information available at the time, which may beflawed or outdated.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