Define the following terms and explain their importance to the study of macroeconomics

Question

a. the relationship between interest rates and velocity
b. lags in stabilization policy
c. rules versus discretion

Answer 1

a. A change in interest rates changes the opportunity costs of holding money balances. If interest rates rise, the opportunity cost of holding money increases and people will hold smaller balances, thus increasing velocity. The opposite will occur if interest rates fall.
b. Policies designed to stabilize the economy work only after some period of time has passed. This time period may contain several lags related to the policy process. One lag may be the time between when a problem occurs and the time when policy makers perceive the problem. Another lag may be the length of time it takes to formulate and execute a policy. And yet another lag represents the time it takes a policy to affect aggregate demand and the economy.
c. Rules versus discretion is another aspect of the debate between Keynesians and monetarists. Monetarists advocate a fixed rule of money supply growth because they do not believe discretionary policy is capable of acting quickly and effectively in stabilizing the economy. Keynesians advocate discretionary policy because they believe that the economy has a slow, self-correcting mechanism and that stabilization policy, although not perfect, can smooth the economy.