8 Mart 2009 Pazar

Policy Pitfalls: Lags in Economic Policy

The core of M.Friedman's case against policy activism and in favour of a monetary rule has always been that there are what he called "long and variable" lags between changes in monetary policy instruments and the ultimate response of target variables like inflation and unemployment.

The essay aim is to distinguish five types of lags for monetary policy and attempt to show estimated the length of these lags. There are five main types of lags, some of which are common to both monetary and fiscal policy, others are more important for one policy type or the other:

1. the data lag
2. the recognition lag
3. the legislative lag
4. the transmission lag
5. the effectiveness lag


In the data lag, policymakers do not know what is going on in the economy the moment it happens. For example, an economic change that starts at the beginning of the month, say November, is not fully evident in the data until the middle of the next month, so that the data lag is about 1.5 months.

In the recognition lag, no policymaker pays much attention to reversals in the data that occur for only one month. Thus, the recognition lag adds two additional months- estimated length of the recognition lag is about 2 months.

In the legislative lag, although most changes in fiscal policy that legislated by Congress, an important advantages of monetary policy is the short legislative lag. For example, once a majority of the Federal Open-Market Committee (FOMC)decides that a monetary policy stimulus is needed, only a short wait is necessary until the next meeting of the FOMC that occurs every month. This brings us to estimated length of the recognition lag is about 0.5 months.

Transmission lag is the time interval between the policy decisions and the subsequent change in policy instruments. Like legislative lag, this lag is a more serious obstacle for the fiscal policy. For example, once the Federal Open-Market Committee (FOMC) has given its order for the open-market managers to make open market purchases, the short-term (federal funds) interest rates declines immediately Often the FED signals that it has shifted policy by changing the re-discount rate; there is no transmission lag at all for such an action. That is to say transmission lag is about zero (0.0).

Evidence on the effectiveness lag is complex; numerous estimates of lags are available and differ substansially. The most difficult to measure, as well as longest, is the effectiveness lag between change in monetary policy and the response of th economy. Evidence on estimated length of the recognition lag is about 15.3 months.
Most of the debate about the lags of monetary policy concerns the length of time required for an acceleration or deceleration in the money supply to influence real output.

Estimated length of Lags (months):

  • Data 1.5
  • Recognition 2.0
  • Legislative 0.5
  • Transmission 0.0
  • Effectiveness 15.3

Total: 19.3 Months

Many studies identified six episodes between 1947 and 1994 and run a statistical test to examine the response of production in the three years after the FED policy shift. For the six episodes estimated effectiveness lag is averages 19 months, even longer than the lags of 12 to 15 months. By the time the economy reacts the Fed's stimulus, the economy might not need additional stimulus and might be doing well on it own.

The total delay between an unexpected event and the economy's reaction to a monetary policy action in response to such an economic event is about 19.3 months.

In sum, five lags (Data, Recognition, Legislative, Transmission, Effectiveness) limit the speed at which policy can respond to a demand or supply shocks. By far the longest for monetary policy is the effectiveness lag. Additional obstacles to effective activist policy, or to policy rules based on targets, are multiplier uncertainty and forecasting errors.

The use of short-run changes in fiscal policy for stabilization purposes has faded, due to persistent government budget deficits. The case against against stabilization with fiscal policy stems from long and variable legislative lags, ineffectiveness of income tax changes, and inefficiency of changing government spending. Both of these fiscal policies rather destabilizing effects on the private economy or the main sources of instability in the private economy.

The case for activist intervention in the economy would work best in the activists' paradise; it would not work in the private economy.