Macroeconomics Study Set 62

Business

Quiz 15 :

The Debate Over Monetary and Fiscal Policy

Quiz 15 :

The Debate Over Monetary and Fiscal Policy

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Explain why lags make it possible that policy actions intended to stabilize the economy will actually destabilize it.
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Lags in stabilization policy
Lags in stabilization policy refer to the time delay, that is, the time difference between the execution of the stabilization policy and its impacts on the economy.
Stabilization policy aims at stabilizing the economic fluctuations, that is, boom and recession.
Time lags in stabilization policy destabilize the economy
If there is a recession, then the expansionary stabilization policy has taken more time to have an impact on the business cycle contraction due to time lag issues. When the policy starts working, the economy itself begins with the recovery stage. Therefore, the stabilization policy speeds up the economy growth, which leads to inflation.
On the other hand, if there is a higher inflation, then the contractionary policy to stabilize the economy has taken more time to have an impact on the inflation, which arises due to business cycle expansion. Before the policy starts working, the economic forces itself brings down the aggregate demand, which in turn leads to recession stage. Therefore, the stabilization policy speeds up the negative economic growth, which leads to depression.
Hence, the time lags in the policy execution cause destabilization.

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Explain why their contrasting views on the shape of the aggregate supply curve lead some economists to argue much more strongly for stabilization policies to fight unemployment and other economists to argue much more strongly for stabilization policies to fight inflation
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Flat aggregate supply curve
The change in level of money supply leads to a change in the price level.
When the aggregate supply curve is much more flat, then the small increase in the price level leads to an increase in the output and employment more than the increase in the price level. Therefore, the small cost of inflation will gain more output and employment.
Hence, the expansionary fiscal or monetary policy is more effective if the aggregate supply curve is flatter.
On the other hand, a small decrease in the price level causes large reduction in the output and employment. Therefore, the huge cost of output and employment controls the small level of inflation. Hence, the contractionary monetary or fiscal policy is not effective if the aggregate supply curve is flatter.
Thus, the economists who believe that supply curve is flatter suggest expansionary policy since it is more effective in increasing the employment without much increase in the price level.
Steep aggregate supply curve
When the supply curve is steep, then the higher increase in the price level causes fewer increases in the output and employment. Therefore, the higher cost of inflation will gain fewer amount of output and employment. Hence, the expansionary fiscal or monetary policy is not effective if the aggregate supply curve is steeper.
On the other hand, the higher reduction in the price level causes fewer decreases in the output and employment. Therefore, contractionary monetary or fiscal policy is controlling higher level of inflation at the cost of fewer output and employment. Hence, contractionary monetary or fiscal policy is much more effective if the aggregate supply curve is steeper.
Thus, the economists who believe that supply curve is steeper suggest contractionary policy since it is more effective in decreasing the inflation.

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Which of the following events would strengthen the argument for the use of discretionary policy, and which would strengthen the argument for rules a. Structural changes make the economy's self-correcting mechanism work more quickly and reliably than before. b. New statistical methods are found that improve the accuracy of economic forecasts. c. A Republican Congress is elected when there is a Democratic president. Congress and the president differ sharply on what should be done about the national economy.
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Discretionary policy
Discretionary policy refers to the policy which is implemented based on the trial and error method. This policy does not support any theory and involves the expectations of the policymakers. This policy is used at times when the economy is not responding according to the fixed rules policy, which leads to failure in achieving its goal.
Rules
Rules refer to the policy that is already designed for achieving the economic goals. This does not consider the present economic situation. This policy is used at times when the economy responds well according to the fixed rules policy, which leads to achievement of its goal.
Self-correcting mechanism
When the structural changes make the economy's self-correcting mechanism work more quickly and reliably, then the economy is responding with the fixed rules. Hence, this strengthens the arguments for rules.
b. Finding new statistical method
The finding of new statistical method that improves economic forecasting will serve to identify the efficient stabilization policy by trial and error method. Hence, this strengthens the arguments for discretionary policy.
c. Republican congress and democratic president
If a republican is elected when there is a democratic president, then a different policy will be proposed by each party. This will lead to destabilization due to the involvement of time lag. If both parties implement the rules, then this will avoid the time lag. Hence, this strengthens the arguments for rules.

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Distinguish between the expenditure lag and the policy lag in stabilization policy. Does monetary or fiscal policy have the shorter expenditure lag What about the policy lag
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Many observers think that the Federal Reserve succeeded in using deft applications of monetary policy to "finetune" the U.S. economy into the full-employment zone in the₁990s without worsening inflation. Use the data on money supply, interest rates, real GDP, unemployment, and the price level given on the inside back cover of this book to evaluate this claim.
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In December 2008, the Fed reduced the federal funds rate to approximately zero. What should it have done then Why What did it actually do
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Use the concept of opportunity cost to explain why velocity is higher at higher interest rates.
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Given all the pros and cons, do you think the Federal Reserve should try to prevent asset price bubbles from forming If so, how would it do that
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How much money by the M1 definition (cash plus checking account balances) do you typically have at any particular moment Divide this amount into your total income over the past 12 months to obtain your own personal velocity. Are you typical of the nation as a whole
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During the year 2008, U.S. economic performance deteriorated sharply. Can this decline be blamed on inferior monetary or fiscal policy (You may want to ask your instructor about this question.)
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The following table provides data on nominal gross domestic product and the money supply (M1 definition) in recent selected years. Compute velocity for each year. Do you see any trend How does it compare with the trend that prevailed from about 1996 to about 2006 (See Figure₁(a).) img
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(More difficult ) The money supply ( M ) is the sum of bank deposits ( D ) plus currency in the hands of the public (call that C ). Suppose the required reserve ratio is 20 percent and the Fed provides $50 billion in bank reserves ( R = $50 billion). a. First assume that people hold no currency (C = 0). How large will the money supply (M) be If the Fed increases bank reserves to R = $60 billion, how large will M be then b. Next, assume that people hold 20 cents worth of currency for each dollar of bank deposits; that is, C = 0.2D. Define the monetary base (B) as the sum of bank reserves (R) plus currency: B = R + C. If the Fed now creates $50 billion worth of monetary base, how large will M be (Hint: You will need a little bit of algebra to figure this out. Remember that the $50 billion monetary base is divided between two purposes: bank reserves and currency.) Now, if the Fed increases the monetary base to B = $60 billion, how large will M be c. What do you notice about the relationship between M and B
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Given the behavior of velocity shown in Figure₁, would it make more sense for the Federal Reserve to formulate targets for M1 or M2
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