Fiscal and monetary policy lags • Automatic stabilizers ...

3.a. The outside lag is the time it takes for a policy action, once implemented, to have its full effect on theeconomy.3.b. Generally, the outside lag is a distributed lag with a small immediate effect and a larger overall effectover a longer time period. The effect is spread over time, since aggregate demand responds to anypolicy change only slowly and with a lag.3.c. Outside lags are longer for monetary policy since monetary policy actions affect short-term interestrates most directly, while aggregate demand depends heavily on lagged values of income, interestrates, and other economic variables. A change in government spending, however, immediately affectsaggregate demand.4. Fiscal policy has smaller outside lags, but significant inside lags. Monetary policy, on the other handhas smaller inside lags and longer outside lags. Therefore large open market operations should beundertaken to get an immediate effect, but they should be partially reversed over time to avoid a largelong-run effect. If the shock is sufficiently transitory and small, policy makers may be best advisednot to undertake any policy change at all.5.a. An econometric model is a statistical description of all or part of the economy. It consists of a set ofequations that are based on past economic behavior.5.b. Econometric models are generally used to forecast the behavior of the economy and the effects ofalternative policy measures.5.c. There is considerable uncertainty about how well econometric models actually represent the workingsof the economy. There is also great uncertainty about the expectations of firms and consumers andtheir reactions to policy changes. Any policy is bound to fail if the information on which it was basedis poor.6. The answer to this question is student specific. The main difficulties of stabilization policy arise fromthree sources. First, policy always works with lags. Second, the outcome of any policy depends on theway the private sector forms expectations and how those expectations affect the public's behavior.Third, there is considerable uncertainty about the structure of the economy and the shocks that hit it.It can be argued that a monetary policy rule would greatly reduce uncertainty about the Fed'spolicy responses. If the government behaved in a consistent way, then the private sector would alsobehave more consistently and economic fluctuations could be greatly reduced. A monetary growthrule would also reduce any political pressure the administration might exert on the Fed. It is ofteninitially unclear whether a disturbance is temporary or persistent and a monetary policy rule wouldprevent policy mistakes in cases where the disturbance is, in fact, temporary. If active monetarypolicy is applied to a temporary disturbance, then the lags involved will guarantee that the economywill actually be destabilized.On the other hand, the workings of the economy are not completely understood and events cannotalways be predicted. Thus it is difficult to argue for a fixed policy rule. Unanticipated largedisturbances warrant an activist policy, especially if they appear to be persistent. It is also possible toconstruct a more activist monetary growth rule. For example, Equation (8) suggests that the annual111