Fiscal and monetary policy lags • Automatic stabilizers ...

• 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