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ch08 - CHAPTER 8 POLICY Solutions to the Problems in the...

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CHAPTER 8 POLICY Solutions to the Problems in the Textbook : Conceptual Problems: 1. The first question you should ask yourself as a policy maker is whether a disturbance is transitory or persistent. You should then ask yourself how long it would take to put a suggested policy measure into effect and how long it will take for the policy to have the desired effect on the economy. In addition, you need to know how reliable the estimates of your advisors are about the effects of the policy. If a disturbance is small and probably transitory, you may be best advised to do nothing, because any measure you take is likely to have its effect after the economy has recovered. Therefore your action might only further aggravate the problem. 2.a. The inside lag is the time it takes after an economic disturbance has occurred to recognize and implement a policy action that will address the disturbance. 2.b.The inside lag is divided into three parts. First, there is the recognition lag, that is, the time it takes for policy makers to realize that a disturbance has occurred and that a policy response is warranted. Second, there is the decision lag, that is, the time it takes to decide on the most desirable policy response after a disturbance is recognized. Finally, there is the action lag, that is, the time it takes to actually implement the policy measure. 2.c. Inside lags are shorter for monetary policy than for fiscal policy since the FOMC meets on a regular basis to discuss and implement monetary policy. Fiscal policy, on the other hand, has to be initiated and passed by both houses of the U.S. Congress and this can be a lengthy process. The exceptions are the so-called automatic stabilizers; however, they only work well for small and transitory disturbances 2.d Automatic stabilizers have no inside lag; they are endogenous and function without specific government intervention. Examples are the income tax system, the welfare system, unemployment insurance, and the Social Security system. They all reduce the amount by which output changes in response to an economic disturbance. 3.a. The outside lag is the time it takes for a policy action, once implemented, to have its full effect on the economy. 3.b.Generally, the outside lag is a distributed lag with a small immediate effect and a larger overall effect over a longer time period. The effect is spread over time, since aggregate demand responds to any policy change only slowly and with a lag. 3.c. Outside lags are longer for monetary policy since monetary policy actions affect short-term interest rates most directly, while aggregate demand depends heavily on lagged values of income, interest 104
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rates, and other economic variables. A change in government spending, however, immediately affects aggregate demand.
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