Question

Under optimal monetary policy, the central bank adjusts its policy based on anticipated rather than current inflation and output gaps because:

Answer 1

Answer: Monetary policy has a long outside lag.

Explanation:

The options are that:

a. It wants to avoid time inconsistency problems.

b. It takes time for the Central Bank to implement its policy decisions.

c. Monetary policy has a long outside lag.

d. Forecast errors are often rather large.

Monetary policy is the use of interest rate and the supply of money to control the economy. Optimal monetary policy helps to maximizes the welfare of individuals and firms given the frictions that occur in the economic environment.

Under optimal monetary policy, the central bank adjusts its policy based on anticipated rather than current inflation and output gaps because monetary policy has such long outside lags. It has a long outside lag because they mainly affect the investment plans of business and a change in the rate of interest might not really have a full effect on the spending on investment for several years.