Country Level Economics:

Policies, Institutions, and

Macroeconomic Performance
Background Notes

Module 1
Aggregate Expenditure and GDP in the Short Run When Prices Are "Sticky"

1.1. Short-Run Income Determination and Price Stickiness

So far, we have assumed that the real income and the price level are given in the short run. This has
helped us study the formation of the interest rate and exchange rate. We now examine how income is
determined in the short run and what happens to the interest rate and exchange rate when we allow
income to be endogenous.

We continue to assume that the price level is exogenously determined. This is a reasonable abstraction
because the price level is indeed inertial (or sticky) in the short run; that is, it has momentum along a
path and does not respond much to supply and demand conditions in the short run. As we will see in
later modules, the reason for this phenomenon is the prevalence of implicit and explicit contracts in the
economy that make it costly to adjust prices.

The key feature of the economy that accounts for most of macroeconomic fluctuations in the short run
is price stickiness.

Over time, prices respond to excess supply or excess demand and become flexible. For this reason,
when we analyze the economy in the long run, we always assume that prices are fully flexible.

o The stickiness and flexibility of prices is what distinguishes the short run macroeconomic conditions
from the long run situations.

To study the determination of aggregate income in the short run, we first examine the factors that affect
the components of aggregate expenditure.

Once we understand these effects, we combine them with the effects of income on the interest rate
and the exchange rate and construct a more comprehensive picture of the economy.

1.2. The Determinants of Aggregate "Preferred" Expenditure

The first step to understand how income is determined in the short run is to examine the way
expenditure decisions are made.

For now, assume that i, e, P, P*, Y*, and all future values of macroeconomic variables are
exogenously given. Also, for the moment suppose the aggregate output, Y, is given. We want to find
out how much will be spent in the economy given these variables. Later, we will deal with feedback
effects from aggregate expenditure to Y and other variables.

Macroeconomics Background Notes 1 1

 There are four categories of expenditure in the economy: government consumption, private
consumption, investment, and net exports.

Given their economic circumstances, there are specific levels of expenditure that economic agents
prefer to have. In the following, we examine the factors that affect the preferred expenditure of each
group of agents who are behind each category of expenditure.

Each group takes the interest rate and the aggregate income in the economy as given and decides how
much it "prefers" to spend. The word preferred is put in quotation marks to highlight the fact that it
refers to preferred levels of expenditure given income, interest rate, and other variables mentioned as
exogenous above. It is a conditional and unconstrained preference.

For now, we will treat government expenditure, G, and net taxes, T, as exogenously determined.

o Government expenditure is determined in a political process and the budget is usually set at the start
of the year. Any changes in G is a policy consideration, which we treat parametrically for now.

o Taxes are a function of income and expenditure in reality. We take them as given for now to
simplify the analysis. Once the model is developed and well understood, we can return to this
assumption and examine the consequences of endogeneity of taxes. It will be easy to show that the
main insights of the model remain unchanged when the assumption is modified in this way.

o We will also reexamine these assumptions in later modules when we discuss the political economy
of fiscal policy.

1.2.1. "Preferred" Private Consumption

Potential determinants of the real preferred aggregate private consumption, C:

o Real income net of taxes: Y T

o Real wealth: W

o Real interest rate: r

o Price level: P

o Expected inflation rate: e

The amount the households prefer to consume depends on their disposable income and wealth. We
write this relationship as a function, C(.), as follows:

C = C(Y T, W).

W is the financial wealth of households (i.e., net value of all assets held by households) including cash,
bonds, stocks, and other ownership rights.

o C is increasing in financial wealth. For example, consumption increases when the stock market or
house prices rise and households find their wealth to be greater.

Macroeconomics Background Notes 1 2

 T is the net taxes collected by the government. We treat T as a policy parameter.

C increases with real disposable income (income net of taxes, Y T).

Figure 1.1. Preferred Private Consumption Is a Function of Income

C
T+
Y0 Private Savings

C(Y T)
C0

45
Y0 Income, Y

For a given level of taxes, T, C increases with real income, Y, but by a smaller amount than the income
increase, as shown in Figure 1.1. That is, the "marginal propensity to consume" out of income is less
than one.

o This means that the graph of consumption vs. income is flatter than then the 45 line. [Note that the
45 line represents the points on which income is equal to income. If the marginal propensity to
consume were 1 every marginal dollar of income were consumed then the consumption schedule
would have a 45 slope.]

Changes in the real interest rate, r, do not have a systematic effect on private consumption.

An increase in the real interest rate has two direct effects on savings:

o Substitution effect

which discourages current consumption in favor of more savings and future consumption.

o Income effect

which raises current consumption by raising the present value of households income in the
future.

o Empirically, the net effect depends on the situation, and, on average, it is not very different from
zero once one controls for other factors.

The price level, P, should not have much impact on the real consumption once one controls for real
income, real wealth, and other factors!

Macroeconomics Background Notes 1 3

 o When the price level rises, nominal income and consumption cost of households rise together.

Real expenditures should not be affected.

Changes in the expected rate of inflation, e, can affect real consumption in the short run.

o Postponing and expediting the purchases of consumer durables

o A rise in the expected inflation rate tends to raise real consumption temporarily, which could in turn
fuel inflation further and destabilize the macroeconomy.

o Expected deflation may reduce real consumption and could be a major concern in deep recession.

1.2.2. "Preferred" Investment

Potential determinants of the real preferred aggregate private investment, I:

o Real interest rate: r

o Real income: Y

o Expected economic growth

o Technological change

o Tax rates

The amount that entrepreneurs and businesses prefer to invest, I, depends on the expected real interest
rate, r, as well as the expected course of the economy and technology.

Figure 1.2. Preferred Investment is a Function of Real Interest Rate

r

r0 0

I(r)

I0 I
Why does investment depend on the expected real interest rate rises and not simply on the nominal
interest rate? The reason is as follows.

o Suppose you can build a house with $100,000 and rent it out. Also, suppose that the rental activity
will bring you $6,000 a year net of all operational costs. You expect the price of the house to rise
with inflation by e = 2% per year. If the interest rate (or the opportunity cost of money) for you is i
= 7% per year, can you make a profit?

Macroeconomics Background Notes 1 4

 o Based on a nominal interest rate calculation, it may appear as if you cannot make a profit because
your net earning from rental activity is $6,000 and your interest costs are $7,000.

o But, in fact, there is an expected capital gain of $2,000 in the nominal value of the house due
to inflation. So, your total expected earnings are $8,000, which is greater than your interest costs.

o In other words, in nominal terms you expect to earn 6% from rent and 2% from inflation. Your costs
in nominal terms will be 7%. Therefore, your expected net gain from the investment is 1% of the
value of the house.

o You can gain from the investment as long as the rental return is greater than i e = r.

Why does the investment expenditure schedule slope downward (i.e., why does investment fall when
the real interest rate rises)?

o The higher the real interest rate, r, is, the fewer the projects that can generate a net profit. Since
investors try to avoid unprofitable projects, less investment will be carried out in the
economy.

o Note that for a given nominal interest rate, an increase in expected inflation will lower the real
interest rate and boost real investment. On the other hand, a decrease in expected inflation reduces
investment expenditure. This is a particularly important consideration in situations when the
economy slows down and people expect deflation while nominal interest rates have been driven
down close to zero. Since in that situation there is little room for the interest rate to decline,
expectation of deflation implies a positive real interest rate, which may discourage investment even
though borrowing may seem cheap in nominal terms.

The higher the expected returns due to improved technological possibilities or expected favorable
economic environment, the higher the investment schedule and the more investment is carried out at
each given real interest rate. Pessimistic views of the future do the opposite.

Figure 1.3.
An Increase in the Expected Return Shifts the Investment Demand Curve to the Right
r

r0

I1(r)

I0(r)

I0 I1 Investment
Macroeconomics Background Notes 1 1
 Given the expected future prospects for the economy, current real income, Y, should not matter for the
investment expenditure decision because investment is about creating capacity for future production
and meeting demand at that point.

o Of course, if a change in current income conveys information about the future and changes the
expected future level of economic activity, then it would have an impact on the investment demand
curve as examined above.

o However, it is not at all clear whether an increase in currency income reflects a future increase or a
future slow down! It all depends on the situation and how economic agents read the signals that they
receive from various corners of the economy.

Taxing corporate profits at a fixed rate has little effect on investment if profits take full account of
revenues and costs, including the cost of capital.

o Given the tax rate, , maximizing gross profits and after tax profits (1 ) yield the same level
of investment.

o However, tax laws do not apply to revenues and costs in the same way.

E.g., profit taxes may discourage investment if they apply to nominal capital appreciation due
to inflation.

o Investment tax credit can lower the price of capital and counteract with profit tax distortions.

1.2.3. "Preferred" Net Exports

Net exports, NX, decline with a rise in the real exchange rate, = eP/P*, and the domestic real income,
Y, but rise with foreign real income, Y*; that is,

NX = NX(eP/P*, Y, Y*).

When the real exchange rate rises (e or P rises or P* declines), home country goods are more expensive
relative to those of other countries. Net exports decline as more is imported and less is exported. 1

1
For the net exports to improve with currency depreciation, imports and exports must be sufficiently elastic,
otherwise as the price of imports rises in terms of domestic output the value of imports will rise fast and the trade
balance will deteriorate. The required condition, known as the Marshal-Lerner condition, often does not hold
immediately after a depreciation, but holds after about a year following the depreciation.
o Marshal-Lerner condition: The sum of the elasticities of exports and imports with respect to the real exchange
rate must be greater than one.
o It takes time for the volumes of exports and imports to adjust to a change in the exchange rate because of
preexisting contractual commitments and the costs of expanding or losing market share by monopolistically
competitive firms.

Macroeconomics Background Notes 1 6

 As home income increases, imports rise, which lowers net exports (the NX curve in Figure 1.4 shifts to
the left).

As foreign income rises, exports rise and raise net exports (the NX curve in Figure 1.4 shifts to the
right).

Figure 1.4. Preferred Net Export Is a Function of Real Exchange Rate

= EP/P*

NX(, Y, Y*)

NX0 Net Exports

1.2.4. Aggregate "Preferred" Expenditure

The aggregate "preferred" expenditure on the domestic output is:

D = C(Y T, W) + I(i e) + G + NX(eP/P*, Y,Y*).

Since e depends on i through the interest parity condition, suppressing the exogenous variables we
can simply write aggregate "preferred" expenditure as a function of aggregate output and nominal
interest rate:

D = D(Y, i).

Aggregate "preferred" expenditure increases as aggregate income rises. That is, the graph of D vs. Y is
upward sloping. (See Figure 1.5.)

o It is important to note that the D curve is flatter than then the 45 line because if Y increases by 1,
the overall increase in D will be less than 1. [C increases by less than 1 and NX declines because
part of the increase in income is spent on imports].

o After a permanent depreciation, trade balance deteriorates in for several months (because imports rise in terms
of domestic output unit) and improves afterward. This is known as the J-curve phenomenon.

Our focus of short run analysis is on periods of about one year. Therefore, we assume that the Marshal-Lerner
condition holds and, therefore, trade balance improves with the depreciation of the domestic currency.

Macroeconomics Background Notes 1 7

 o The intercept of the D curve is positive because there is always some "subsistence" consumption
(and possibly other forms of expenditure) even when income is zero. Such expenditure may be
financed by past savings (wealth) or by borrowing.

o The above features ensure that the D curve always crosses the 45 line at some positive Y.

Figure 1.5. Aggregate "Preferred" Expenditure Schedule

Y=D D(Y, i)
D

D0 0

45

0 Y0 Y

The aggregate "preferred" expenditure schedule in the diagram of D vs. Y shifts up when

o The interest rate, i, declines

o The domestic currency depreciates (e declines)

o e, G, P*, or Y* rise

o P or T decline

o Investment prospects improve (e.g., new technology makes investment more profitable)

5.2.5. Short-Run Equilibrium in the Output Market

Now, let us see what happens if Y is no longer a given number. For the time being, we assume that
there is no supply constraint; that is, firms are able to meet the expenditures on the domestic output at
the price level, P, which we take as given.

Recall from the fundamental macroeconomic identity (Module 2 in the previous course) that
aggregate expenditure must always be equal to aggregate income, Y (which is the same as aggregate
output).

Therefore, whatever the public spends becomes income. As a result, when the public starts with a given
level of income that is not equal to its preferred aggregate expenditure, it may soon find out that its
income is different from what was initially perceived. This will induce a change in expenditure until

Macroeconomics Background Notes 1 8

 aggregate expenditure becomes equal to aggregate income, where there are no longer incentives
for change and we are in equilibrium.

The economy will be in equilibrium only if: Y = D(Y,i).

In other words, in equilibrium, Y must be such that the expenditure that it induces i.e., D(Y,i)
becomes equal to itself. In other words, the equilibrium occurs at the crossing point of the D
schedule with the 45 line (which represents Y = D).

o Recall that the D schedule always crosses the 45 line at some income level, Y0, because D(Y,i) is
flatter than the 45.

Figure 1.6. If Y < D(Y, i), Income Will Be Rising

D D(Y,

D0

Y0
Expenditure
higher than
income
i i

45

Y0 Y1 Income, Y

If income happens to be at some point below Y0, expenditure will be greater than output and firms will
see that their inventories are depleting. So, they will hire more workers and produce more. This will
raise income. (See Figure 1.6.)

Figure 1.7. If Y > D(Y, i), Income Will Be Declining

D
Y0
D(Y, R)
D0

Expenditure lower
than income
lowers income

45

Macroeconomics Background Notes 1 Y1 Y0 Income, Y9

 If income happens to be at some point above Y0, expenditure will be less than output and firms will see
that their inventories are piling up. So, they will reduce their production and layoff their workers. This
will reduce income. (See Figure 1.7.)

5.3. The Impact of Interest Rate on the Equilibrium Output in the Goods Market: The IS Curve

In our study of money markets, we treated aggregate output, Y, as given and showed that an increase in
Y tends to raise the interest rate because it raises the demand for money.

Now that we have seen how output is determined given the interest rate, a key question is, how do
changes in the interest rate affect the output?

We learned that if the interest rate declines, investment rises. Also, the domestic currency depreciates
and raises the net exports. Both effects shift up the aggregate expenditure schedule and raise the
equilibrium output.

Equilibrium output can be plotted as a declining function of the interest rate (Figure 1.8).

o This relationship is known as the IS curve.

Formally, the IS curve is the locus of points in the (Y, i) diagram that represent the equilibrium level of
real income, Y, in the goods market for various nominal interest rates, i, given the price level, P.

Macroeconomics Background Notes 1 10

 Figure 1.8. Formation of the IS Curve:
As Interest Rate Declines, Income in the Goods Market Rises

i0 > i1 D(Y, i1)

1
D1

D0
0 D(Y, i0)

45

0 Y0 Y1 Y

i0 0

1
i1

IS

0 Y0 Y1 Y

5.4. Short-Run Equilibrium in the Economy

IS tells us what the income level of the economy would be given the interest rate.

We have seen before that the interest rate itself depends on income via the money market equilibrium,
which we called the LM curve.

Macroeconomics Background Notes 1 11

 Putting the two curves together, as in Figure 1.9, allows us to understand how i and Y are jointly
determined.

Figure 1.9. Path of the Economy Toward Equilibrium in Both Goods and Money Markets

1
i
LM

i0
0

IS

0 Y0 Y

If the economy is not in equilibrium initially (say at point 1), money market clears quickly for the given
level of income (the economy goes to point 2), and then income adjusts and drives the interest rate
and income toward the short-run equilibrium (point 0).

1.5. Macroeconomic Equilibrium, Economic Shocks, and Fiscal and Monetary Policies in the Short
Run

In this module, we use the IS-LM model developed above to analyze government and central bank
policies. We focus on the short-run effects of temporary changes in the money supply, Ms, government
expenditure, G, and tax collection, T.

We ask: how do the government's decisions to temporarily change fiscal and monetary policies
affect GDP, the interest rate, the exchange rate, and variables that depend on them in the short run?

In this analysis, we take the short-run price level and the expectations about the future course of the
economy as given. Endogeneity of those factors will be discussed in future modules.

We distinguish between temporary and permanent changes in policies because temporary changes do
not affect future conditions of the economy and, therefore, do not alter expectations as the permanent
changes do.

Macroeconomics Background Notes 1 12

1.5.1. Equilibrium Income and Interest Rate Response to Fiscal and Monetary Policies in the
Short Run

Consider a temporary increase in Ms that has no impact on the long-term prospects of the economy. In
particular, assume that the temporary monetary expansion has no effect on ee. In the short run,

o The IS curve remains put because money supply does directly enter the IS equation. Money supply
does affect the interest rate and can influence the aggregate expenditure in product market
(and, therefore, income) that way. But, that would constitute a movement along the IS curve.

o However, the money supply increase does affect the LM curve and makes it flatter (or shifts it
downward) because increased money supply lowers the interest rate at each given level of income.
The crossing point of IS and LM curves moves down the IS curve. i declines and Y increases
(Figure 1.10).

Figure 1.10.
The Impact of a Temporary Rise in Money Supply on Income and Interest Rate

i M1 > M0

LM0

0
i0 LM1

i1 1

IS0

0 Y0 Y1 Y

o The reason why income increases is twofold: lower interest rates stimulate investment and make
the currency depreciate, which encourages net exports.

o Note that net exports do not necessarily rise in the process because while the depreciation of the real
exchange rate tends to raise net exports, the rise in income tends to lower net exports. As a result,
the overall effect of money supply increase on net exports depends on the relative responsiveness of
the net exports to and Y and on the extent to which Y increases as a result of the response of
investment to the decline in the interest rate.

Now consider a temporary increase in G that has no impact on the long-term prospects of the economy.
As before, assume that the temporary fiscal expansion has no effect on ee.

Macroeconomics Background Notes 1 13

Figure 1.11. The Impact of a Temporary Rise in Government Expenditure on the IS Curve

G1 > G0 D(Y, i, G1)

D

1
D1

0
D0
D(Y, i, G0)

45
0 Y0 Y1 Y

i0 0 1

IS1
IS0

0 Y0 Y1 Y
A temporary increase in G raises aggregate expenditure and shifts the IS curve to the right in the short
run. Figure 1.11 shows how this shifts takes place.

As the IS curve shifts to the right, income expands and the interest rate rises along the LM curve (see
Figure 1.12).

o The rise in the interest rate makes the exchange rate to appreciate.

o Higher interest rate reduces investment and higher exchange rate reduces net exports.

o Therefore, government expenditure crowds out investment and net exports.

Macroeconomics Background Notes 1 14

 Figure 1.12.
The Impact of a Temporary Rise in Government Expenditure on Income and Interest Rate
G1 > G0
i

LM0

1
i1

0
i0

IS1

IS0

0 Y0 Y1 Y

1.5.2. Short-Run Economic Shocks and the Short-Run Macroeconomic Equilibrium

An increase in the expected inflation or expected future profitability (e.g., a

technological improvement) tends to encourage investment, which raises aggregate expenditure.
This shifts the IS curve to the right and increases income, interest rate, and exchange rate.

Conversely, a decrease in the expected inflation (especially deflation) tends to discourage investment
and to lower aggregate expenditure. This shifts the IS curve to the left, which lowers income, interest
rate, and exchange rate. (See Figure 1.13.)

o Essentially, deflation encourages people to postpone investment type expenditures, including

consumption expenditures that can wait. This reduces current aggregate demand, which in turn
reduces income and employment.

o As we will see in a later module, if expected deflation persists, the longer-term effects can be
devastating to the economy because as income and employment drop, over time firms may try to
attract more business by lowering their prices while cutting production and laying off workers. This
can induce continued deflation and can cause further postponement of expenditure and decline in
aggregate expenditure and income. The result can be a vicious circle that leads to a deep and
prolonged recession.

Macroeconomics Background Notes 1 15

 Figure 1.13.
The Short-Run Macroeconomic Consequences of a Decline in Expected Inflation

As e I(Re)

i
LM0

i0

i1
IS0

IS1
Y1 Y0 Income, Y

An increase in P* or Y* tends to boost net exports, which raises aggregate expenditure. This shifts the IS
curve to the right and increases income, interest rate, and exchange rate. If those foreign parameters
decline, the shift is going to be in the opposite direction, similar to Figure 1.13.

A decrease in T increases consumption expenditure for each given Y. This raise aggregate expenditure
and shifts the IS curve to the right. As a result income, interest rate, and exchange rate all rise. The
outcome is similar to the situation depicted in Figure 1.12 for the case of increased public expenditure.

Figure 1.14.
The Impact of a Temporary Rise in the Price Level on Income and Interest Rate
P EP/P* NX
P1 > P0
Also, e I(Re)
LM1
P money
i
demand rises

LM0
i1
i0

IS0
IS1

Y1 Y0 Income, Y

Macroeconomics Background Notes 1 16

 A temporary increase in P raises the demand for money and rotates the LM curve upward.

At the same time, the increase in P has two effects that both tend to shift the IS curve to the left
(Figure 5.14):

o A temporary increase in P causes the real exchange rate to appreciate for every interest rate (and the
corresponding nominal exchange rate). This discourages net exports at every nominal interest rate.

o The increase in the current price level, P, given the future price level, could also mean that the price
level will rise less in the coming year and, thus, expected inflation must decline. In that case, the
current jump in the current P could reduce investment at every given nominal interest rate because it
raises the real interest rate for every given i. It could also lead to some postpone consumption
expenditure. (These effects would not exist if e remains unchanged.)

On the whole, the result of a rise in the current P is a definite decline in real income, as shown
in Figure 1.14.

However, the impacts on the interest rate and nominal exchange rate are ambiguous. The rise
in the interest rate shown in Figure 1.14 is a possible outcome, but it is not always the case.

The impact on the net exports is also ambiguous because while the appreciation of the real
exchange rate tends to lower net exports, the decline in income tends to raise net exports.
There is also an ambiguous effect through the possible changes in the interest rate. As a result,
the overall effect depends on the relative responsiveness of the net exports to and Y and on
the extent to which Y decreases as a result of the response of investment to possible changes in
the interest rate.

The following table summarizes above results.

Table 1.1
Short Run Macroeconomic Impact of Temporary Increases in Policy Parameters
and in Other Exogenous Variables When the Price Level is Exogenous
Impact on
Exogenous Variables Type of Variable Symbol IS and LM Y i e NX
Government Fiscal Policy G IS shifts to the right + + +
Consumption
Net Taxes Fiscal Policy T IS shifts to the left +

s
Money Supply Monetary Policy M LM rotates downward + ?
Expected Inflation Other Exogenous e
IS shifts to the right + + +
Expected Profitability Other Exogenous IS shifts to the right + + +
Price Level Other Exogenous P LM rotates upward, ? ? ?
IS shifts to the left
Foreign Price Level Other Exogenous P IS shifts to the right + + + +
*
Foreign Income Level Other Exogenous Y IS shifts to the right + + + +

Macroeconomics Background Notes 1 17

1.6. Macroeconomic Shocks and Stabilization Policies

1.6.1. The Use of Temporary Changes in Monetary and Fiscal Policies for Stabilization

Fiscal and monetary policies can be used to counter the effects of shocks to the economy.

Suppose foreign income declines and reduces the demand for our exports. This shifts the IS curve to
the left and reduces our income and interest rate. [In Figure 1.15, this move is represented by the shift
from IS0 to IS1 position.]

o An increase in G can shift the IS curve back to its original position and restore income and interest
rate. [This shifts the IS curve back to the IS0 position.]

o An increase in M can shift the LM curve down and restore Y, but the interest rate will decline and
the domestic currency will depreciate further. [In Figure 1.15, this effect is shown by the shift of the
LM curve to the LM1 position, while the IS curve remains at the IS1 position.]

Figure 1.15. Stabilization through a Combination of Fiscal and Monetary Policies

i
LM0

i0 0

i1 1 IS0

LM1
i2 2
IS1

0 Y1 Y0 Y
The two policies may also be combined. The choice of the policy mix depends on whether the
government can implement monetary or fiscal policy more effectively. It also depends on the extent to
which one values government expenditure relative to investment and exports.

1.6.2. The Perils of Using Imperfect Policy Tools

Policymakers always face difficulties in forecasting the impact of shocks and policy responses.

o Economists typically forecast by one of two methods:

Building an index of variables that seem to be correlated with future movements in the
economy (e.g., Index of Leading Economic Indicators)

Macroeconomics Background Notes 1 18

 Building models of the economy and using assumptions about the trends in the values of the
model's parameters to map the future course of the economy

o The index of leading economic indicators is helpful but can contain large errors since the
constituent indicators themselves contain large errors and our knowledge of their relationships with
future economic activity is crude.

o Economic models are imperfect because our knowledge of the economy's details is limited. Even
though our forecasts may be correct on average, the error of individual forecasts can be large.

o All evidence shows that forecasts contain significant errors and uncertainty, making it difficult
to design the right policies that are meant to address future problems rather than the past ones!

A related problem is that there are variable and unpredictable lags in policy response to
macroeconomic shocks:

o Inside lags: It takes time to recognize that a shock has occurred and put appropriate policy
responses into effect.

o Outside lags: It takes time for policy responses to take effect.

o Fiscal policy has a long inside lag (usually six months to a year or more) due to the budget process
and coordination in executive and legislative branches of the government.

o Monetary policy has a long outside lag (usually 6 months or more) due to the time it takes for
businesses to change their investment plans in response to interest rate changes.

Lags in policy response may render stabilization policy ineffective or counterproductive because they
are not fully predictable and may have unanticipated variations. By the time a policy takes effect,
the shock may have disappeared or other shocks to the economy may require a different response.

Active macroeconomic policies can also suffer from an important problem known as time-
inconsistency: Policymakers want to induce certain expectations in the public to get people to act in
ways that stabilize the economy. This requires strong commitment to certain policies. For example, in
highly inflationary environments, policymakers would like to make the public believe that fiscal
and monetary policies will be contractionary, and, thus, inflation will be contained so that
consumers and investors need not accelerate their purchases and fuel inflation further. However,
when people curtail their spending, policymakers may find it costly to follow through with their
promised policies, which reduce employment or the benefits that politicians get from expansionary
policies. If people expect such deviation from promised policies, they may come to expect more
inflation and bid up prices faster, destabilizing the economy further.

The problems of imperfections in policy tools should not be exaggerated:

o The economics profession has accumulated a great deal of knowledge and experience about how to
evaluate and address major macroeconomic shocks.

Macroeconomics Background Notes 1 19

 Nevertheless, the difficulties in responding to shocks have an important implication: policymakers
should not pretend that they can closely control the economy and "fine-tune" it.

If the government uses active policy in response to macroeconomic shocks, it should use policy tools
judiciously and reserve such actions for larger fluctuations.

Macroeconomics Background Notes 1 20

 Appendix
A Comparison with Krugman, Obstfeld, and Melitz (KOM) Book
All of the above analysis can be carried out in a diagram that shows the exchange rate versus income.

We have seen that as income rises, the exchange rate appreciates due to the increase in money demand
and interest rates. KOM call this relationship the AA curve.

We have also seen that an increase in e reduces net exports and, therefore, diminishes expenditure.
Krugman and Obstfeld call this relationship the DD curve. The DD curve is the equivalent of the IS
curve but relates the exchange rate, rather than the interest rate, to income.

1
e
AA

e0 0

DD

0 Y0 Y

A temporary increase in Ms shifts AA downward, but does not affect the DD curve.

o Domestic currency depreciates and income increases.

e AA0

AA1

e0 0

e1 1

DD0

0 Y0 Y1 Y

Macroeconomics Background Notes 1 21

 A temporary increase in G only affects the output market in the short run and has no impact on
long-term prospects of the economy: DD shifts outward.

o Domestic currency appreciates and income increases.

AA0

1
e1

0
e0 DD1

DD0

0 Y0 Y1 Y

Macroeconomics Background Notes 1 22