[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Review and Practice
SUMMARY
1. The actual fiscal deficit increases in a recession as tax
revenues decline. This process provides an important
automatic stabilizer. To measure discretionary shifts in
fiscal policy, economists look at the full-employment
budget deficit.
2. The aggregate demand–inflation (ADI) curve depends
on the monetary policy rule used by the central bank.
The slope of the policy rule affects the slope of the ADI
curve, while shifts in the policy rule are reflected in
shifts in the ADI curve.
3. If the central bank wants to keep inflation stable, it must
adjust its policy rule whenever the equilibrium fullemployment
real interest rate changes. The policy rule
must be shifted up if the full-employment real interest
rate increases, leading to a higher nominal interest rate
at each inflation rate.
4. The monetary policy rule shifts if the central bank alters
its target for inflation. If it reduces its inflation target,
the policy rule shifts up, leading to a higher nominal
interest rate at each rate of inflation.
5. Both fiscal and monetary policies can affect aggregate
demand and output in the short run. They have different
effects on the interest rate. A fiscal expansion raises the
real interest rate; a monetary expansion lowers the real
interest rate. Consequently, investment will be higher
in the short run if monetary policy is used to stimulate
the economy.
6. The inside lag is shorter for monetary policy than
for fiscal policy. The outside lag is shorter for fiscal
policy.
KEY TERMS
automatic stabilizer
discretionary action
full-employment deficit
monetary policy rule
inside lag
outside lag
REVIEW QUESTIONS
1. What are automatic stabilizers and how do they affect
the economy?
2. What happens to the government surplus when the
economy goes into a recession? What happens to the
full-employment surplus when the economy goes into
a recession?
3. How does the slope of the ADI curve depend on the
monetary policy rule?
4. If the central bank wants to keep inflation equal to its
target, how must the monetary policy rule shift if the
equilibrium full-employment real interest rate falls?
5. How does the monetary policy rule shift if the central
bank’s target for inflation is reduced? How does this
reduction affect the ADI curve?
6. In addition to the effects of monetary policy on aggregate
demand that operate through the real interest rate,
what other channels are there through which monetary
policy may affect aggregate expenditures?
7. Compare the effects of monetary and fiscal policies on
the level of investment and the composition of output.
PROBLEMS
1. Why would the economy be more stable or less stable if
there were no automatic stabilizers?
2. In recent years, many central banks have placed
increased emphasis on controlling inflation. Suppose the
central bank of the nation of Economica decides that it
will move interest rates sharply whenever inflation
differs from its desired target of 1 percent. Previously,
policymakers in Economica had adjusted interest rates
only slightly in response to inflation.
(a) How will this switch in policy affect the central
bank’s monetary policy rule?
(b) How will it affect the slope of the ADI curve?
(c) Suppose Economica suffers an inflation shock that
increases inflation. Use a graph to illustrate how
output and inflation respond under both the old and
the new policy rules.
752 ∂ CHAPTER 33 THE ROLE OF MACROECONOMIC POLICY