Chapter 18

Q1. What are the inside lag and the outside lag? Which has the longer inside lag—
monetary or fiscal policy? Which has the longer outside lag? Why?
Inside lag is the time between the shock and policy response while the outside lag is the time it
takes for policy to affect economy.

Fiscal policy has longer inside-lag than monetary policy. For instance, fiscal policy takes years
for a tax change to be proposed and becomes law. Monetary policy, on the other hand, once Fed
decides a policy change is needed, it can make the change in days or weeks.

Monetary policy has longer outside lag than fiscal policy. For instance, increases in money
supply will cause interest rate to fall and investment to increase. But, firm’s investment plans are
often made far in advance (they are very careful in making investment plan as it is a huge
money). Thus, from the time, Fed acts to the time effects are shown in real GDP, it may take up
to 6 months.

Q5. What is meant by the “time inconsistency” of economic policy? Why might
policymakers be tempted to renege on an announcement they made earlier? In this
situation, what is the advantage of a policy rule?
Problem of time inconsistency arises because of the expectation of future policies affect how
people act today.

For instance, policy makers announce a policy they intend to implement in the future in order to
influence the expectation held by the private decision-makers. Once the private decision markers
have acted on their expectations, the policymakers may be tempted to revoke on their
announcement. (hints: imagine playing chess)

In monetary policy, suppose the Fed announces a policy to reduce inflation and everyone
believes the announcement,

Chapter 20
Q5. Explain how a financial crisis reduces the aggregate demand for goods and services.
Financial crises will cause the bank to reduce loans and increase interest rate. Hence,
consumption and investment will fall, which in turn reduces aggregate demand.

Q7. What are the pros and cons of using public funds to prop up a financial system in
crisis?
Benefits: helps to maintain confidence in the financial system that subsequently, helps to
facilitate future economic growth.
Problem: unfair to taxpayers. Bailout can lead to moral hazard.