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
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
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-