Back To CourseEconomics 102: Macroeconomics
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Jon has taught Economics and Finance and has an MBA in Finance
Fiscal and monetary authorities have the same goals in mind - a stable but growing economy - but they go about it in different ways. First it's important to distinguish between the terms 'monetary' and 'fiscal' since they're used so frequently. The word 'monetary' refers to the money supply of a nation, which is controlled by the central bank. The word 'fiscal,' however, means 'budget' and refers to how the government spends money. Monetary policy is basically when the central bank changes the money supply, while fiscal policy is talking about changes in the government's spending, taxes, or transfer payments. Here's what we're going to focus on in this lesson: while the central bank and the government use their own tools to try and improve economic conditions, their policies take time to start working. A policy lag is the lag between the time an economic problem arises, such as recession or inflation, and the effect of a policy intended to counteract it. Notice I just used the word 'counteract.' Economists sometimes use the word 'countercyclical policy,' which simply means stabilizing a recessionary or overheating economy using monetary or fiscal policy.
Just think about it from the standpoint of a vacationer. Imagine you're driving a car with no spare tire - definitely not recommended, by the way - and you run over a large screw that punctures a small hole in one of your tires. At first you don't notice a problem. However, within an hour or so you discover the tire has been contracting for some time. Had you known about it right away, you could have gotten it patched up and continued on your way. But by this time the tire is flat and you're waiting for a tow truck. You're stuck overnight in a hotel in the small town of Lemmeloose, and you definitely need a ride.
Alright, let's look at that story from an economic standpoint. In macroeconomics, the car is, of course, the economy, and the car with a flat tire represents an economy going through recession. The point is that fiscal and monetary authorities sometimes step into the driver's seat of the economy but often don't recognize a problem right away. It may take some time to decide on the appropriate strategy, time to implement the fiscal or monetary policies, and even more time for policy actions to become effective.
When it comes to fiscal and monetary policy, timing is very important. For the rest of this lesson, let's take a look at four different types of policy lags.
When you encountered a flat tire, it took a while for you to recognize it. The same thing happens with fiscal and monetary policies. Recognition lag is the amount of time it takes for fiscal or monetary authorities to recognize a problem in the economy. This type of lag occurs primarily because it takes time for the economy to be tracked and for economic reports to be published. Many economic indicators tend to be backward-looking, meaning that they're telling you what's already happened instead of what is happening right now. Since much of the data is old by the time it's reviewed, it may take weeks or months before an economic problem, such as a recession or inflation, is recognized. So that's the recognition lag; the problem's been recognized.
Once government leaders identify an economic problem such as recession, the Congress must agree on a course of action. This often requires a law to be written, passed, and signed by the President. If you think back to the vacation in the story, once you recognized the flat tire, it probably took you a few minutes to decide how to respond. Should you call a tow truck? Should you try and flag someone else down on the road? This was your decision lag. In economics, decision lag is the amount of time it takes for fiscal or monetary authorities to make a decision regarding how best to handle an economic problem.
When your car had a flat tire, you decided on a strategy to respond. Let's say that you called the tow truck. When you did, you probably sat around a while waiting for the tow truck to arrive. Once the car was towed, it took additional time before the car reached the nearest repair shop. This was your implementation lag. Looking at it economically, since the federal government is such a large organization, it may take weeks or months for the appropriate agencies to be contacted and for decisions to be carried out after fiscal policy actions have been decided on. Economists would say it this way: implementation lag is the amount of time it takes for fiscal and monetary policy decisions to be implemented.
Finally, when your car was at the repair shop being worked on, it took time for the car to get fixed and for the repair to be effective so the car would be drivable again. When this happens in the economy, we call it an effectiveness lag. Here's how economists describe it: effectiveness lag is the amount of time it takes for a fiscal or monetary policy's effects to produce the desired result. Even after a policy is implemented, it still takes time for it to work.
Here's an example most of us can identify with. One of the fiscal policy decisions could be a reduction in tax rates. Tax cuts are often used by the government to try and increase consumer spending and get the economy going again. Why does this matter? Because consumer spending represents about 2/3 of economic output! If you can get consumers to go shopping, then economic output will definitely go up. But even if the government issues a tax cut, it takes time for consumers to spend the money. Even an increase in government spending takes time to filter through the economy.
When the central bank increases the size of the money supply, interest rates go down immediately. However, it still takes time for consumers and businesses to take advantage of those low rates and increase their borrowing so they can invest into the economy. As you can see, whether it's fiscal policy or monetary policy, timing is an important issue.
While both monetary and fiscal policies take time to work, monetary policy typically works faster than fiscal policy. Monetary policy decisions happen faster because the central bank is not a government bureaucracy and because the tools they use - such as changing the money supply or lowering the reserve ratio - can be used more quickly than the amount of time it takes for Congress to debate a bill, pass it, and implement it through the right agencies. For example, when the Federal Reserve wants to lower nominal interest rates, all it has to do is announce a decision during a monthly meeting, then pick up the phone and make a quick call to buy some government bonds. For these reasons, monetary policy tends to work faster than fiscal policy.
It's time to summarize the key points: A policy lag is the lag between the time an economic problem arises and the effect of a policy intended to counteract it. Policy lags happen because government actions aren't instantaneous. They take time. Sometimes they take a very long time. There are four main types of policy lags:
If you want to remember the four types of policy lags, just think back to the story of the vacationer who had a flat tire and needed a ride - R I D E.
There is much less of a time lag for monetary policy than fiscal policy. Monetary policy decisions can be implemented much faster than fiscal policies because the central bank is not a government bureaucracy and the tools they use are more efficient than the tools of fiscal policy.
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Back To CourseEconomics 102: Macroeconomics
15 chapters | 123 lessons