cancel the exam so that he or she does not have to grade it. Similarly,the ithtenoitsifg an inc e that it will not negotiation ts believe that they have nothing to gain by kidnapping hostages,then they will not do so.However,once hostages are kidnapped,the government faces a strong temptation to negotiate and make concessions.In monetary policy,suppose the Fed announces a policy of low inflation,everyone believes the noun nt The Fed then s an tive to raise inflation ause it faces off between inflation and unemployment.The prob em with situat in which time inconsistency arises is that people led to distrust policy announcements.Then students do not study for their exams terrorists kidnap hostages,and the Fed faces an unfavorable tradeoff.In these situation a rule that commits the policymaker to a particular policy can sometimes help the policymaker achieve his or her goals -students study terrorists do not take hostages.inflatior remains lov 8.The cyclically adjusted budget deficit is the budget deficit corrected for the effects of the bu ess cycl other words,it is the budget deficit that the governn would be running if unemployment were at the natural rate.(It is also called the full-employment budget deficit.)Some economists have proposed the rule that the cyclically adjusted budget deficit always be balanced.Compare this proposal to a strict balanced-budget rule.Which is preferable?What pro do you se with the rule requiringa balanced cvclically adjusted 8.A rule requiring a cyclically adjusted balanced budget has the potential to overcome. at least partially,the first two objections to a balanced-budget rule that were raised in this chapter.First,this rule allows the government to run countercyclical fiscal policy in order to stabilize the ec That is.the 1 deficits recessions,when taxes automatically fall and expenditures automati cally rise These automatic stabilizers affect the deficit but not the cyclically ad justed deficit Second,this rule allows the government to smooth tax rates across years whenincome is especially low or high- -it is not necessary to raise tax rates in recessions or to cut them in booms n the other handthis rule only partially these two objections,sinc the government can only run a deficit of a certain size which might not be big enough Also,a cyclically adjusted balanced budget does not allow the government to smooth tax rates across vears when expenditure is especially high or low as in times of war or peace.(We might take account of this by allowing an exemption from the balanced budget rule special wa )Thi doe not allow the govemment toverom the third bctionthchaptinch government cannot shift the burden of expenditure from one generation to another when this is warranted.Finally,a serious problem with a rule requiring a balanced cyclically adjusted budget is that we do not directly observe this budget.That is.we cancel the exam so that he or she does not have to grade it. Similarly,the government has an incentive to announce that it will not negotiation with terrorists.If terrorists believe that they have nothing to gain by kidnapping hostages,then they will not do so.However,once hostages are kidnapped,the government faces a strong temptation to negotiate and make concessions. In monetary policy,suppose the Fed announces a policy of low inflation, everyone believes the announcement.The Fed then has an incentive to raise inflation because it faces a favorable tradeoff between inflation and unemployment. The problem with situations in which time inconsistency arises is that people led to distrust policy announcements.Then students do not study for their exams terrorists kidnap hostages,and the Fed faces an unfavorable tradeoff. In these situation a rule that commits the policymaker to a particular policy can sometimes help the policymaker achieve his or her goals—students study,terrorists do not take hostages. inflation remains low. 8.The cyclically adjusted budget deficit is the budget deficit corrected for the effects of the business cycle. In other words,it is the budget deficit that the government would be running if unemployment were at the natural rate.(It is also called the full-employment budget deficit.)Some economists have proposed the rule that the cyclically adjusted budget deficit always be balanced.Compare this proposal to a strict balanced-budget rule.Which is preferable?What problems do you see with the rule requiring a balanced cyclically adjusted budget? 8.A rule requiring a cyclically adjusted balanced budget has the potential to overcome, at least partially,the first two objections to a balanced-budget rule that were raised in this chapter.First,this rule allows the government to run countercyclical fiscal policy in order to stabilize the economy.That is,the government can run deficits during recessions,when taxes automatically fall and expenditures automatically rise. These automatic stabilizers affect the deficit but not the cyclically adjusted deficit. Second,this rule allows the government to smooth tax rates across years whenincome is especially low or high—it is not necessary to raise tax rates in recessions or to cut them in booms. On the other hand,this rule only partially overcomes these two objections,since the government can only run a deficit of a certain size,which might not be big enough. Also,a cyclically adjusted balanced budget does not allow the government to smooth tax rates across years when expenditure is especially high or low,as in times of war or peace.(We might take account of this by allowing an exemption from the balanced budget rule in special circumstances such as war.)This rule does not allow the government to overcome the third objection raised in the chapter,since the government cannot shift the burden of expenditure from one generation to another when this is warranted. Finally,a serious problem with a rule requiring a balanced cyclically adjusted budget is that we do not directly observe this budget.That is,we