chap14 - CHAPTER 14 Stabilization Policy Questions for...

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Questions for Review 1. The inside lag is the time it takes for policymakers to recognize that a shock has hit the economy and to put the appropriate policies into effect. Once a policy is in place, the outside lag is the amount of time it takes for the policy action to influence the economy. This lag arises because it takes time for spending, income, and employment to respond to the change in policy. Fiscal policy has a long inside lag—for example, it can take years from the time a tax change is proposed until it becomes law. Monetary policy has a relatively short inside lag. Once the Fed decides a policy change is needed, it can make the change in days or weeks. Monetary policy, however, has a long outside lag. An increase in the money supply affects the economy by lowering interest rates, which, in turn, increases investment. But many firms make investment plans far in advance. Thus, from the time the Fed acts, it takes about six months before the effects show up in real GDP. 2. Both monetary and fiscal policy work with long lags. As a result, in deciding whether policy should expand or contract aggregate demand, we must predict what the state of the economy will be six months to a year in the future. One way economists try to forecast developments in the economy is with the index of leading indicators. It comprises 11 data series that often fluctuate in advance of the economy, such as stock prices, the number of building permits issued, the value of orders for new plants and equipment, and the money supply. A second way forecasters look ahead is with models of the economy. These large- scale computer models have many equations, each representing a part of the economy. Once we make assumptions about the path of the exogenous variables—taxes, govern- ment spending, the money supply, the price of oil, and so forth—the models yield pre- dictions about the paths of unemployment, inflation, output, and other endogenous variables. 3. The way people respond to economic policies depends on their expectations about the future. These expectations depend on many things, including the economic policies that the government pursues. The Lucas critique of economic policy argues that traditional methods of policy evaluation do not adequately take account of the way policy affects expectations. For example, the sacrifice ratio—the number of percentage points of GDP that must be forgone to reduce inflation by 1 percentage point—depends on individuals’ expectations of inflation. We cannot simply assume that these expectations will remain constant, or will adjust only slowly, no matter what policies the government pursues; instead, these expectations will depend on what the Fed does. 4. A person’s view of macroeconomic history affects his or her view of whether macroeco-
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This note was uploaded on 09/18/2010 for the course ECON 1210 taught by Professor Mannigs.waters during the Fall '08 term at Broome Community College.

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chap14 - CHAPTER 14 Stabilization Policy Questions for...

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