Fiscal and monetary policy lags • Automatic stabilizers ...

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