Lags in

Effects of
Economic
Policy
ESKEVI
 Introducti 2

on!
Macroeconomic policy is essential
for maintaining economic stability by
influencing inflation, employment, and
economic growth. Governments and
central banks use monetary and fiscal
policies to regulate economic conditions.

However, the effectiveness of

these policies is hindered by various
time lags.
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Types of Lags
Recognition Lag
01 Lag between need for action and the recognition of that need

Administrative Lag
02 Lag between recognition of need and implementation of appropriate
policies
Operation Lag
03 Lag between adoption of policy and the final effect of that policy

Recognition lag + Administrative lag = Inside Lags

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Recogniti
01 on Lag
Example

● Lag between need for action ● A recession may have already

and the recognition of that started before indicators such as
need GDP decline or rising
unemployment become evident.
● Time taken by policymakers to
realize that an economic ● Empirical evidence suggests that
problem exists. central banks, such as the Federal
Reserve, have historically
● Difficult to know the occurrence
recognized the need for monetary
of a turning point in a business
action only several months after a
cycle and recognise the need
recession or boom begins.
for action by the authorities
 5

Administrat
02 ive Lag
Example

● Lag between recognition of need ● If a government decides to

and implementation of appropriate introduce a fiscal stimulus
policies package to counteract a
recession, it must go through
● Also known as decision lag,
several stages of approval in the
occurs due to bureaucratic
legislature before being
procedures, legislative processes,
implemented.
and political debates
● In many cases, monetary policies
● The length of this lag varies based
have shorter administrative lags
on the complexity of the policy and
than fiscal policies.
the efficiency of the decision -
making process.
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Operation
03 Lag
Example

● Lag between adoption of policy ● If the central bank reduces

and the final effect of that policy interest rates to encourage
investment and spending, it may
● Refers to the time it takes for an
take several months or even
implemented policy to produce
years for businesses to respond
measurable effects in the
by increasing investments and for
economy
consumers to adjust their
● Also known as Effects Lag spending habits.

● This lag is further divided into

two components : Intermediate
& Outside Lag
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Intermediate
Lag Outside Lag

The time between policy The period between

implementation and its direct changes in monetary or
influence on economic variables fiscal conditions and their
such as interest rates, money eventual impact on
supply, taxes, and public aggregate demand,
expenditure. income, and output.
 ● X axis - Time lags
● Y axis - Aggregate income/output 8

Graphical ● T - Upper turning point of the

business cycle

Representat
● R - Recognition lag
● A - Administrative lag
● E - Effects lag
ion ● Curve Y - movements in national
income before policy changes.
● EP and EP1 - two alternative effects
path in the effects lag which indicate
alternative outcomes based on policy
implementation.
● Effects lag EP - movement in income
and output when expansionary policy
controls business cycle downwards,
Y1 represents resultant movement of
income
● Effects lag EP1 - income path when
restrictive policy controls boom, Y2 is
 9

Countercyclical vs Automatic
Policies
Countercyclical Policy Automatic Policy
Adjusting monetary and fiscal policy to
Following a fixed rule where money supply
counter economic fluctuations (e.g.,
Definition and fiscal deficit grow at a steady rate
easing during recessions, tightening
regardless of economic conditions.
during booms).
Eliminates the issue of policy delays by
Time Lag Long and variable lags cause delays,
maintaining a stable growth rate of money
Effect making policy responses often mistimed.
supply.
Economic Can destabilize the economy due to poor Prevents extreme fluctuations by
Stability timing of policy implementation. maintaining consistent policy measures.

Inflation Risk of inflation during expansion due to Stable money supply growth prevents
Control excessive monetary easing. prolonged inflationary pressures.
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Countercyclical Policy Automatic Policy

Recession Risk of deepening recessions due to Ensures liquidity remains stable, allowing
Control delayed policy effects. aggregate demand to recover naturally.

Political Prone to political bias and short-term Free from political interference as policies
Influence considerations. follow a fixed rule.

Forecasting Requires accurate economic forecasting, Avoids reliance on economic forecasting,

Issues which is often unreliable. reducing uncertainty.
Supported for its ability to minimize
Friedman’s
Opposed due to its destabilizing effects. uncertainty and smooth economic
Preference
fluctuations.

Friedman favored the automatic framework over countercyclical policy.

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Friedman’s view
$ He gives two reasons in support of the automatic framework as
against the discretionary policy action.

$ First, discretionary anti cyclical policy is often dominated by goals

other than, and even contradictory to, stabilisation when the
monetary and fiscal authorities adopt such measures as pegging
bond yields, halting gold outflows, etc. But the automatic
framework cannot be easily exploited for other purposes.

$ Second, the automatic framework would be free from inertia and

political considerations that inhibit the reversal of discretionary
policies when they turn out to be in the wrong direction.
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Graphical
Representat
ion
Nature of business cycles
in the case of two types of
Policies.

The dotted curve shows the

fluctuations in economic
activity when countercyclical
monetary policy is adopted.

The smooth curve shows mild

fluctuations in economic
activity under the automatic
framework.
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Main criticisms
$ Keynesians and other economists disagree with Friedman’s
approach, arguing that discretionary policies are necessary
to respond effectively to economic fluctuations.

$ They contend that moderate adjustments in monetary and

fiscal policy can be implemented in a timely manner,
within a period of 3-6 months, to counteract economic downturns
and overheating.

$ Keynesians advocate for a combination of monetary policy to

control booms and fiscal policy to mitigate recessions

$ Whichever policy is adopted, the lag problems and economic

fluctuations cannot be completely eliminated.
Time lags in macroeconomic policy pose significant 14
challenges to achieving economic stability. While recognition,
administrative, and operation lags delay the effectiveness of
monetary and fiscal interventions, economists differ on how
best to address these issues.

Friedman’s automatic framework seeks to avoid

destabilisation by setting fixed policy rules, while Keynesians
argue for discretionary interventions to manage economic
fluctuations.

Ultimately, no single approach can completely eliminate time

lags, but policymakers must consider these delays when

Conclusio
designing and implementing economic strategies to enhance
policy effectiveness.

n!
 THANK
YOU
REFERENCE : ML Jhingan Macro
Economic Theory 12th edition - 2010