Fiscal and monetary policy lags • Automatic stabilizers ...

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