Question

1. Address the inside and outside lags associated with fiscal and monetary policy. If one policy suffers more significant lags, why use it? (3)

2. Read "Did the Fed Cause the Great Recession?" (Pages 454-455). Provide your thoughts on this historical downturn in our economy. Distinguish the culprit(s). How is the banking crisis a strong case for moral hazard? (3)

Answer 1

‘Inside lag’ refers to the amount of time that a government or its central bank takes to respond to an economic shock through its fiscal or monetary policies. The ‘outside lag’ refers to how much time an economy takes in itself to effect the policy decisions like fiscal and monetary policies on itself. Fiscal policies are actions taken by the government to counter the economic variations and it would include policy effects like selling or buying of government bonds, increase or decrease of government spending in an economy, taxation policies etc. Monetary policies refer to the policy decisions taken by the central bank who is the monetary authority of a nation. It follows activities like open market operations, reduction or increase of interest rates etc to influence the changes in an economy.

                                    An economic system is always characterised by turbulences. With the rise of globalisation practices across the globe, the effects on an economy now takes only less time to reach another country which is in close transition through trading or similar mechanisms. It would mean that any global economy is bound to economic shocks at any time. The economic shocks refer to various external effects on an economy like natural disasters, parallel economy effects, global financial crisis etc which would have some profound influences like inflationary or deflationary effects in an economy. In such cases, both the government and the monetary authority follows certain measures so as to bring back the economy to a stable operation level.

                                    In the above circumstances, it should be realised that both the fiscal and monetary policies would have inside and outside lags. The inside lag would be caused by the time it takes to generate the right action and the outside lag would be due to the effects that the shock has already caused to the economy. Thus, inside and outside lag in economic decision making could not be avoided completely. The one thing that can be done is to reduce the time lag of inside lag so that much outside lag effects are not caused. Cater Moreover, if one of the policies fails to effect in one situation it doesn’t mean that we should not follow that policy and depend completely on the other. The fiscal policies generally affect the policy decisions in an economy and the monetary policy generally affects the money supply in an economy. Thus, a mix of fiscal and monetary policies are essential for an economy so that the policy making and money supply goes hand in hand and would bring back the economic stability.