Question

1) Explain the time lag of an expansionary monetary policy to affect output and inflation (refer to Page 406-408)

2) Refer to the countercyclical policy (page 411), it describe the central bank follow the countercyclical policy to deal with an expenditure shock in 2020. Let’s consider the same expenditure shock: AE curve shifts to the right in 2020 and returns to its initial position in 2021. Suppose the Federal Reserve anticipates the shock in this practice: in 2019, it knows what will happen in the following two years. Assuming time lags of monetary policy exist, can the Federal Reserve keep output and inflation constant? If it can, explain how; if it can’t, explain why not.

Answer 1

Q1) Expansionary monetary policy means that the central bank will cut the interest rates. This should lead to a rise in investment and consumer spending. This is because lower interest rates reduce the cost of borrowing. Lower interest rates should lead to higher aggregate demand.

There may be time lags for a number of reasons which dampen the growth in output and inflation.

1) Commerical Bank delays:  Commercial banks may delay in passing the policy rate cuts to rate cuts in its lending, which especially happens in the developing countries.

2) Fixed interest rates: Many Consumers may have a contract setting a fixed rate mortgage. This means interest payments are fixed at the beginning of the contract. Rate cuts will not affect such contract holders.

3)Awareness. It is hard to imagine that all the consumers have perfect knowledge of financial variables. They may not check interest rates every at regular intervals and may fail to take advantage of rate cuts.

4) Uncertainty: People might want to wait if they perceive the rate cuts to be temporary. They would want to enter into new contracts if they believe that the rate cut advantage is permanent (forward guidance)