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

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rates, and other economic variables. A change in government spending, however, immediately affects aggregate demand. 4. Fiscal policy has smaller outside lags, but significant inside lags. Monetary policy, on the other hand has smaller inside lags and longer outside lags. Therefore large open market operations should be undertaken to get an immediate effect, but they should be partially reversed over time to avoid a large long-run effect. If the shock is sufficiently transitory and small, policy makers may be best advised not 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 of equations that are based on past economic behavior. 5.b. Econometric models are generally used to forecast the behavior of the economy and the effects of alternative policy measures. 5.c. There is considerable uncertainty about how well econometric models actually represent the workings of the economy. There is also great uncertainty about the expectations of firms and consumers and their reactions to policy changes. Any policy is bound to fail if the information on which it was based is poor. 6. The answer to this question is student specific. The main difficulties of stabilization policy arise from three sources. First, policy always works with lags. Second, the outcome of any policy depends on the way 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's policy responses. If the government behaved in a consistent way, then the private sector would also behave more consistently and economic fluctuations could be greatly reduced. A monetary growth rule would also reduce any political pressure the administration might exert on the Fed. It is often initially unclear whether a disturbance is temporary or persistent and a monetary policy rule would prevent policy mistakes in cases where the disturbance is, in fact, temporary. If active monetary policy is applied to a temporary disturbance, then the lags involved will guarantee that the economy will actually be destabilized. On the other hand, the workings of the economy are not completely understood and events cannot always be predicted. Thus it is difficult to argue for a fixed policy rule. Unanticipated large disturbances warrant an activist policy, especially if they appear to be persistent. It is also possible to construct a more activist monetary growth rule. For example, Equation (8) suggests that the annual monetary growth rate should be increased by two percent for every one percent that unemployment increases above its natural rate. Such a rule is based on the quantity theory of money equation (which relates money supply growth to the growth of nominal GDP) and on Okun's law (which relates the unemployment rate to economic growth). Obviously, because of the long lags for monetary policy, any monetary growth rule will work much better in the long run than in the short run. Fiscal policy rules may make more sense than monetary policy rules, since fiscal policy has long inside lags but shorter outside lags. In a way, built-in stabilizers, although generally not considered "rules", already provide some stability without any inside lag. Many of the arguments against

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monetary policy rules are also valid for fiscal policy rules and many economists oppose them. The frequently proposed constitutional amendment requiring an annually balanced budget is an example of a fiscal policy rule. There are significant problems associated with such an amendment, since it would greatly limit the government's ability to undertake active fiscal stabilization policy. 7. The arguments for a constant growth rate rule for money are based on the quantity theory of money equation, that is, MV = PY. From this equation we can derive %P = %M - %Y + %V. If the long-run trend rate of real output (Y) and the long-run trend of velocity (V) are assumed to be fairly stable, and if wages and prices are sufficiently flexible, then a constant monetary growth rate (M) would insure a constant rate of inflation, that is, a constant rate of change in the price level (P). Also, since monetary policy has long outside lags, active monetary policy can actually be more destabilizing than stabilizing. In addition, since we do not know exactly how the economy works or may react to specific policies, it is best to follow a rule rather than undertake actions that have uncertain outcomes. However, rules are not without problems, as they would not allow flexibility in responding to major disturbances. 8. Dynamic inconsistency occurs if, after having committed themselves to a specific policy action designed to achieve a long-run objective, policy makers find themselves in a situation where it seems advantageous to abandon their original policy, in order to achieve a short-run goal. Such action will impede the long-run objective. 9. Real GDP targeting is the best option if the primary policy goal of monetary policy is to achieve full employment. If policy makers forecast potential GDP correctly, then full employment combined with low inflation can be achieved. However, real GDP targeting bears the greater risk that the secondary goal of achieving a low inflation rate will be missed. If the rate at which potential GDP grows is overestimated, then policy makers may stimulate the economy too much. In this case, they will not be successful in achieving price stability. By targeting nominal GDP, the central bank creates a policy tradeoff between inflation and unemployment. If the rate at which potential GDP grows is overestimated and policy makers stimulate the economy too much, we will get less growth but also less inflation than under real GDP targeting. Which targeting approach should be chosen depends greatly on how steep or flat the Phillips curve is perceived to be. Technical Problems: 1. If actual GDP is expected to be $40 billion below the full-employment level and the size of the government spending multiplier is 2, then government spending should be increased by $20 billion over its current level. For the next period, when actual GDP is expected to be $20 billion below 106

potential, government spending should be cut by $10 billion from its new level, that is, to $10 billion over its original level. In period three, when actual GDP is expected to be at its full-employment level, the level of government spending should again be cut by $10 billion from the last period's level to bring it back to the original level of Period 0. 2.a. If there is a one-period outside lag for government spending, then nothing can be done to close the current GDP-gap. The government should decide to spend $10 billion more for the next period and reduce spending again to its original level after that. 2.b. Graph I below shows the path of GDP for Problem 1 with no outside lag and Graph II shows the path of GDP for problem 2.a. with a one-period outside lag. In each of the graphs the path of actual GDP is shown, first assuming that no policy action takes place and then assuming that the policies proposed in Problems 1 and 2.a. are undertaken. Graph I GDP potential GDP GDP potential GDP

0 GDP with fiscal policy

time Graph II

0 GDP without fiscal policy

time

GDP potential GDP

GDP potential GDP

0 GDP with fiscal policy

time

0 GDP without fiscal policy

time

3.a. Since the government multiplier for the first period is 1, the level of government spending must be increased by G = $40 billion to close the GDP-gap of $40 billion. But since the government multiplier in the next period for the amount spent in this period is 1.5, the effect of an increase in government spending in the first period by $40 billion would be an increase in GDP by $60 billion in the second period. 3.b. For the second period a GDP-gap of $20 billion is expected. However, as we saw in 3.a., GDP will increase by $60 billion in the second period if the government increases spending by $40 billion in the first period. Therefore, the government has to reduce spending in the second period by $40 billion 107

from its new level (back to its original level), since the multiplier for a spending change in the same period is 1. 3.c. In this problem, fiscal policy has an outside lag. This means that the effect of an increase in government spending is felt both in the period in which the spending increase takes place and (to an even larger degree) in the following period. The increase in government spending needed to close the GDP-gap in the first period is guaranteed to overshoot the desired goal in the next period. Thus the government will be forced to reverse its increase in spending to the original level in the second period to offset the destabilizing effect. In a case like this, the government has to be much more active in its fiscal policy than in a situation where no distributed lag exists. 4. If there is uncertainty about the size of the multiplier, then fiscal policy becomes much more complicated. If the multiplier is 1, then an increase in government spending by $40 billion will close the GDP-gap in the first period. If the multiplier is 2.5, we will overshoot potential GDP by $60 billion. An increase in spending by 40/2.5 = $16 billion is optimal if the multiplier is 2.5. Thus a cautious government will probably increase spending by no more than $16 billion in the first period, and then reduce the level of spending by $8 billion in the next period ($8 billion above the original level). Such a policy action is designed to close the GDP-gap to some degree over the first two periods while never overshooting potential GDP. In Period 3 we will again be back at the fullemployment level. The extent to which a less cautious government might exceed these suggested spending increases depends largely on that government's level of concern about unemployment versus inflation. 5. To follow an established rule for its policy, the Fed needs to know the source of each disturbance. If a disturbance comes from the goods sector, it is better to have a monetary growth target; if the disturbance comes from the money sector, it is better to have an interest rate target. a. Assume a disturbance comes from the money sector. If an increase in money demand increases the interest rate, the Fed should try to maintain a constant interest rate by increasing the supply of money. This will re-establish the old equilibrium values of the interest rate and output and effectively offset the disturbance. b. Assume a disturbance comes from the goods sector. If an increase in autonomous investment increases the interest rate, then it is not advisable to maintain a constant interest rate. Trying to lower the interest rate again by increasing the money supply would aggravate the disturbance. On the other hand, maintaining a constant money supply, while not offsetting the disturbance, will at least not make things worse. 6.a. Students will have to check the Federal Reserve Bulletin in early 2000 and compare the forecasts of the Federal Reserve Board with the actual performance of the economy in 1999. 6.b. Regardless of how detailed it is, no econometric model can accurately represent the economy, since we do not completely understand the way the economy works. Therefore, we can never expect perfect forecasts. It is impossible to incorporate all the relevant information on which individuals and firms base their expectations about the future and to determine how these expectations affect actions in any given situation. Forecasts are generally based on the information available at the time, which may be flawed or outdated. In addition, any unexpected change, such as a supply shock, an unanticipated

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international change, or an unanticipated domestic policy change, can render the initial predictions wrong. Additional Problems: 1. Define and distinguish between inside and outside lags. The inside lag is the time period it takes to implement a policy action after an economic disturbance is recognized. It is divided into the recognition lag (the time it takes for policy makers to realize that a disturbance has occurred and that a policy response is warranted), the decision lag (the time it takes to decide on the most desirable policy response), and the action lag (the time it takes to implement the policy measure). The outside lag is the time it takes for a policy measure, once implemented, to have an effect on the economy. 2. How do long lags in investment spending affect the usefulness of a government policy that tries to stabilize the economy via investment tax credits? Long lags in investment spending suggest that investment tax credits should not be used for fine-tuning but may be useful in responding to a prolonged disturbance. However, the lag is much shorter for temporary investment tax credits, which often speed up existing or planned investments. Therefore investment tax credits can be used for short-run stabilization, even though uncertainty about their frequency and duration may create unstable swings in investment spending. 3. "Monetary policy should be employed only sparingly since it operates with long and variable lags." Comment on this statement. There are lags both in recognizing that there is a need for a policy response to a disturbance and in designing a particular policy measure. Once the program is in place, it takes additional time to affect economic activity. For example, expansionary monetary policy lowers short-term interest rates and then, after a lag, also lowers long-term interest rates, which, in turn, increases investment spending. Before committing themselves to increased investment spending, firms need to determine whether the cost of capital has risen temporarily or permanently. Ultimately, aggregate demand is affected and then a series of induced adjustments in output and spending will take place. Therefore, while the inside lags for monetary policy actions are short, it takes time for monetary policy to affect aggregate demand to the desired degree since there is an additional distributed lag (the dynamic multiplier process). If monetary policy is employed, it should be done with caution, since it can be destabilizing. But the fairly successful monetary policy of the Fed over the last two decades indicates that it is possible to undertake active monetary policy without destabilizing the economy. 4. "Monetary stabilization policy is difficult for the Fed because of the existence of long and variable outside lags. But if the Fed knew the exact length of these lags, active monetary stabilization policy would always be successful." Comment on this statement.

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If lags are long and variable, it becomes very difficult to predict exactly when a certain policy measure is going to have its desired effect on the economy. It is thus difficult to successfully implement countercyclical stabilization policies. If the timing of a policy measure is misjudged, the economy may actually be destabilized rather than stabilized. If lags were long but fixed, it would be much easier to judge when to implement a policy measure. However, this is unrealistic since there is still considerable uncertainty about the workings of the economy and about the accuracy of the theoretical models used in forecasting. 5. Is the fact that economists often put decimal points in their forecasts an indication that they can be very accurate in their predictions? Why or why not? The econometric models from which economic forecasts are derived are based on the historical record of the economy. However, not every disturbance can be predicted with accuracy. An economic forecast represents only a best estimate of how the economy will behave based on (often incomplete) information and a set of initial assumptions. A forecast of 1.5% real economic growth should be interpreted as growth anywhere in the range of 1 to 2 percent. 6. True or false? Why? "The Fed can always maintain full employment if it uses its policy instruments appropriately." False. Monetary policy works with long and variable outside lags. Furthermore, by the time the Fed has identified the source and duration of an economic disturbance and decided on the appropriate response, the shock will already have done some damage. Fine tuning the economy through the use of monetary policy is impossible. 7. True or false? Why? "Announcing a policy may be just as effective as actually implementing it." False. There may be short-run effects of policy announcements if individuals act in anticipation of the announced change. Such announcements in and of themselves, however, do not have lasting implications for economic activity unless the government consistently follows through with the proposed policy. Indeed, making announcements and then not following through threatens the credibility and reputation of policy makers and may ultimately render policy announcements destabilizing.

8. "Policy makers committed to full employment encounter major problems if they underestimate the natural unemployment rate." Comment on this statement. Policy makers, who assume that the natural rate of unemployment is 4% rather than its actual 5.5%, will try to stimulate the economy through expansionary policies as soon as the rate of unemployment goes above 4%. But this will decrease unemployment only temporarily since the economy has a tendency to go back to the true natural rate. To maintain the 4% level, policy makers will have to stimulate the economy again and again which will, in turn, create inflationary pressure. Since inflation reduces real wages, workers will ask for wage increases and we will enter the so-called wage-price spiral.

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9. Briefly discuss the arguments for and against fine tuning the economy. Fine tuning the economy involves the use of policy tools to counteract every disturbance in the economy, even small ones. Since there are lags in stabilization policies and considerable uncertainty about whether a disturbance is temporary or permanent, a very active stabilization policy in the face of very small disturbances may actually be destabilizing. If a decision to fine tune is made, minimal initial policy responses to economic disturbances are advised, especially if there is uncertainty about the size of the fiscal or monetary policy multiplier. 10. What are the relative merits of a cold turkey over a gradualist approach to fight inflation? In your answer discuss the concept of time inconsistency and the importance of credibility. The key question for governments desiring to reduce inflation is how cheaply (in terms of lost output) they can achieve a desired inflation rate. A gradual strategy attempts a slow and steady return to low inflation by reducing monetary growth slowly in an attempt to avoid a significant increase in unemployment. This approach takes a lot longer than the cold-turkey approach that attempts to reduce inflation quickly by immediately and sharply reducing monetary growth. The central question here is how flexible wages and prices are and how fast expectations adjust. With a cold turkey approach, inflation and inflationary expectations will be reduced faster. An increase in the level of unemployment leading to a decrease in the level of output will result in the short run in either case, but the economy will eventually adjust back to the full-employment level of output. The term time inconsistency refers to the problem that the Fed faces when a policy may look appropriate at the time it is announced, but when it is time to execute it, it may no longer look desirable. If the Fed consistently tries to keep inflation under control, even though it may cause some unemployment in the short run, the public will keep inflationary expectations low and is more likely to adjust wage demands downwards. Credibility makes it easier for the Fed to conduct its policies, since the public knows what to expect and will react predictably. For example, if the Fed were to follow a monetary growth rule, then people could more easily anticipate the effects of a disturbance and adjust to it. But if the Fed had a reputation of changing its monetary policy often and unpredictably, its policies might not have the desired effects, since people might not react in the desired way. 11. "A cold-turkey approach is better than a gradualist approach for fighting inflation, since it requires a shorter time to establish a long-run equilibrium at a desired lower inflation rate." Comment on this statement. The gradualist approach lowers money growth over a long period of time to minimize the severity of any resulting recession. The cold-turkey approach achieves the reduction in the inflation rate more quickly, but at the cost of a significant increase in short-run unemployment. Normative considerations determine the relative merits of the two approaches. The cold-turkey approach may benefit from a credibility bonus, since workers and firms do not have to guess whether the government is really committed to lowering the inflation rate. They may therefore reduce their inflationary expectations faster and the economy will adjust back to full-employment much faster. However, if long-term contracts exist, wages and prices cannot adjust quickly and a rapid return to a low-inflation equilibrium at full-employment is fairly unlikely.

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12. Comment on the following statement: Achieving a zero inflation rate by imposing a monetary growth rule will result in more economic stability, a higher growth rate, and a better income distribution. According to the equation (%P) = (%M) - (%Y) + (%V), a zero inflation rate (%P) can be easily achieved if monetary growth (%M) is kept at a rate equal to the long-term growth rate of real income (%Y) adjusted for velocity (%V). A monetary growth rule works well if the economy is inherently stable, if most disturbances are small and of short duration, and if velocity is fairly stable or at least predictable. But such a monetary growth rule would tie the central bank's hands if a large disturbance occurred. The cost of long and high unemployment can be very high, especially if wages and prices are fairly rigid. Periods of high and long unemployment particularly affect low-income workers with low skills and therefore the income distribution worsens. While some economists contend that low inflation countries have a higher average economic growth rate, there is no good evidence available for this assertion. 13. Would you support a monetary growth rule that maintains the rate of money supply at 3%, which is slightly higher than the long-term trend of potential output? Why or why not? Explain your answer. The answer to this question is student specific. A student who believes that the economy and velocity are very stable and that disturbances are fairly transitory will probably support such a rule. The argument for such a rule is that it may create more rational expectations in the private sector regarding policy actions by the Fed. Thus, after a disturbance, the private sector would adjust more rapidly and the economy would go back to full employment much more quickly. A student, who believes that disturbances may be persistent, that wages and prices do not adjust rapidly, and that long periods of unemployment are costly, would advocate a more activist approach. This is especially true if velocity is not very stable. Recent experience indicates that a discretionary approach promises more success in keeping the economy close to full employment without causing unacceptable inflation. 14. "Credibility is extremely important in the conduct of monetary policy." Comment on this statement and relate your answer to the concept of dynamic inconsistency. Assume there is a supply shock and the Fed has to decide whether to keep unemployment low by implementing expansionary monetary policy or to concentrate on keeping inflation under control. The dynamic inconsistency approach suggests that the Fed should refrain from a policy response that may look appropriate in the short run but will prove unproductive in the long run. If the Fed always chooses to accommodate a supply shock, people will come to expect such a reaction and will incorporate the assumption of a higher inflation rate in their wage demands. But if the Fed consistently tries to keep inflation under control (even though it may cause some unemployment in the short run), people will lower their inflationary expectations. The Fed will keep its reputation as an inflation fighter, and the economy will adjust back to full employment fairly rapidly. 15. "Policy rules are always preferable to discretionary policy." Briefly comment on this statement.

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Policy rules predetermine the actions of policy makers and thus eliminate the uncertainty of government actions. This may reduce some of the instability that arises from mistaken expectations. Unfortunately, however, rules do not allow enough flexibility to respond to unforeseen events and cannot accommodate the range of policies required to reduce large and prolonged disturbances. 16. Explain why it is important for the Fed to have credibility in its effort to maintain price stability. Credibility is very important for the Fed, since consistent government actions lead to more accurate private sector expectations. For example, if the Fed were to follow a monetary growth rule, then people could more easily anticipate the effects of a disturbance and could adjust to it. If the Fed consistently tries to keep inflation under control, even though it may cause some unemployment in the short run, people keep their inflationary expectations low and adjust their wage demands downwards. But if the Fed has a reputation of changing its monetary policy often and unpredictably, its policies may not have the desired effects, since people may not react in the desired way. As a result, active monetary policy may actually be destabilizing. 17. "A monetary policy rule is preferable to discretionary stabilization policy." Comment on this statement. In your answer discuss the arguments for and against fine tuning the economy. Policy rules make the actions of policy makers predictable and thus eliminate the uncertainty that comes from unanticipated government actions. They also may reduce instability arising from mistaken expectations. However, rules do not allow flexibility in responding to unforeseen large and prolonged disturbances. Only a very strong proponent of monetarism or the rational expectations approach would propose a strict monetary growth rule. Fine tuning the economy involves the use of policy tools for all (even small) disturbances. But since there are always policy lags and uncertainty about the length of disturbances, fine-tuning may actually be destabilizing. Therefore small policy responses should be undertaken initially and revised later, as more information about the true nature of the disturbance becomes available. 18. "The economy always adjusts back to the full-employment level of output, so policy makers should not be concerned with undertaking active stabilization policy. Instead they should establish more credibility by following a well-defined policy rule." Comment on this statement. Since wages are flexible in the long run, the economy will always eventually adjust back to full employment. According to the Phillips-curve analysis, the economy will be at full employment as long as expected inflation is equal to actual inflation. Therefore, policy makers can create more rational expectations by following a monetary growth rule and announcing its monetary growth targets in advance. In this case, money illusion will not exist and any announced reduction in the growth rate of money supply will lead to lower inflation without much increase in unemployment. But if there is no such rule and the Fed has a reputation of changing its monetary policy often, policies may not have the desired effects, since people may not react in the desired way. It should be noted that an activist monetary growth rule can be designed in which money supply growth changes with changes in the unemployment rate. Fiscal policy rules can also be designed (such as a balanced budget amendment, for example). Whether policy rules actually make sense depends on how

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fast the economy adjusts back to full employment and how flexible wages and prices are. In the case of large disturbances, rules limit the flexibility of policy makers to respond to a disturbance that may result in a high rate of unemployment. Finally, there are the questions of whether policy rules should be announced in advance and who has the authority to change them if necessary. Finally, if disturbances are perceived to be small it may be better to rely on automatic stabilizers.

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