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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
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
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
4. A person’s view of macroeconomic history affects his or her view of whether macroeco-
nomic policy should play an active role or a passive role. If one believes that the econo-
my has experienced many large shocks to aggregate supply and aggregate demand, and
CHAPTER 15 Stabilization Policy
168 Answers to Textbook Questions and Problems
5. The problem of time inconsistency arises because expectations of future policies affect
how people act today. As a result, policymakers may want to announce today the policy
they intend to follow in the future, in order to influence the expectations held by pri-
vate decisionmakers. Once these private decisionmakers have acted on their expecta-
tions, the policymakers may be tempted to renege on their announcement.
For example, your professor has an incentive to announce that there will be a final
exam in your course, so that you study and learn the material. On the morning of the
exam, when you have already studied and learned all the material, the professor might
be tempted to cancel the exam so that he or she does not have to grade it.
Similarly, the government has an incentive to announce that it will not negotiate
with terrorists. If terrorists believe that they have nothing to gain by kidnapping
6. One policy rule that the Fed might follow is to allow the money supply to grow at a con-
stant rate. Monetarist economists believe that most large fluctuations in the economy
result from fluctuations in the money supply; hence, a rule of steady money growth
would prevent these large fluctuations.
A second policy rule is a nominal GDP target. Under this rule, the Fed would
announce a planned path for nominal GDP. If nominal GDP were below this target, for
example, the Fed would increase money growth to stimulate aggregate demand. An
Problems and Applications
1. Suppose the economy has a Phillips curve
u= un– α(π– Eπ).
As usual, this implies that if inflation is lower than expected, then unemployment rises
above its natural rate, and there is a recession. Similarly, if inflation is higher than
expected, then unemployment falls below its natural rate, and there is a boom. Also,
suppose that the Democratic party always follows a policy of high money growth and
high inflation (call it πD), whereas the Republican party always follows a policy of low
real economy. We do observe a political business cycle pattern to inflation, in
which Democrats have high inflation and Republicans have low inflation.
Now suppose that contracts are long enough that nominal wages and prices
cannot be adjusted immediately. Before the result of the coin flip is known, there
is a 50-percent chance that inflation will be high and a 50-percent chance that
b. If the two parties take turns, then there will be no political business cycle to
unemployment, since everyone knows which party will be in office, so everyone
knows whether inflation will be high or low. Even long-lasting contracts will take
the actual inflation rate into account, since all future inflation rates are known
with certainty. Inflation will alternate between a high level and a low level,
depending on which party is in power.
2. There is a time-inconsistency problem with an announcement that new buildings will
be exempt from rent-control laws. Before new housing is built, a city has an incentive
3. The Federal Reserve web site (www.federalreserve.gov) has many items that are rele-
vant to a macroeconomics course. For example, following the links to “Monetary Policy”
(http://www.federalreserve.gov/policy.htm) take you to material from the Federal Open
Market Committee meetings and to testimony given by the Federal Reserve Chairman
twice a year to Congress. Other links take you to speeches or testimony by the
More Problems and Applications to Chapter 15
1. a. In the model so far, nothing happens to the inflation rate when the natural rate of
unemployment changes.
b. The new loss function is
Chapter 15 Stabilization Policy 169
170 Answers to Textbook Questions and Problems
We now differentiate with respect to inflation π, and set this first-order condition
equal to zero:
dL/dπ= 2α2(π– Eπ) – 2αun+ 2 γπ = 0
or,
π= (α2Eπ+ αun)/(α2+ γ).
Of course, rational agents understand that the Fed will choose this level of infla-
tion. Expected inflation equals actual inflation, so the above equation simplifies
to:
π= αun/γ.
c. When the natural rate of unemployment rises, the inflation rate also rises. Why?
The Fed’s dislike for a marginal increase in unemployment now rises as unem-
ployment rises. Hence, private agents know that the Fed has a greater incentive
