What it means
Economic policy does not work instantly. A central bank can cut interest rates in a day, but households and companies may take months to change their borrowing, spending and hiring in response.
Economists usually describe policy lags in two groups. The inside lag is the time it takes policymakers to recognise a problem, decide what to do and put the decision into practice, while the outside lag is the time it takes the action to affect the economy, and response lag is one name for that outside part.
Monetary policy tends to have a short inside lag, since a central bank can act quickly, but a long and uncertain response lag. Fiscal policy, meaning government spending and taxation, often has a long inside lag, because legislatures must debate and approve measures, but its response lag can be shorter when money goes quickly to households.
The practical difficulty is timing. A policy chosen to fight a downturn may only start to work after the economy has already begun to recover, and it can then add to inflation, which is why policymakers prefer gradual and well-signalled changes.
The idea matters to business managers as well. An interest rate cut announced today does not mean sales will rise next month, and a finance team should plan around the typical delay in its sector, not around the headline.
The same concept applies inside companies. A price rise, marketing campaign or new sales process may take several quarters to show up in revenue, and judging it too early can lead to the wrong conclusion.
In practice
Real-world examples.
Example
A central bank cuts interest rates to boost lending. Mortgage lenders pass on the cut quickly, but business investment plans take months to be revised, so the effect on output arrives well after the decision.
Example
A government announces tax cuts for households in a downturn. Because the cuts take effect through lower withholding in later pay periods, spending rises gradually over the following two quarters.
Example
A retailer raises the quality of its customer service training in January. The finance team knows from experience that repeat purchases respond slowly, so it waits until the third quarter before judging whether the programme paid back its $150,000 cost. It also tracks customer satisfaction scores in the meantime, as an earlier signal that the training is working.
Formula
Calculation
Total policy lag = recognition lag + decision lag + implementation lag + response lag; Inside lag = recognition + decision + implementation.
Suppose a government approves a $20,000,000,000 stimulus package to counter a slowdown. It takes 3 months to recognise the slowdown in the data, 2 months to agree the package, and 1 month to start paying out, so the inside lag = 3 + 2 + 1 = 6 months. The response lag is 9 months before spending raises output noticeably. Total policy lag = 6 + 9 = 15 months, by which time the economy may have recovered without help.Case study
Seen in the real world.
Northfield is an illustrative, fictional economy whose central bank noticed a sharp fall in business activity. It cut its policy rate by 1 percentage point within a month, and officials expected a rapid recovery.
Six months later, activity had barely moved, and politicians demanded further cuts. The bank's economists explained that previous episodes showed a response lag of 9 to 12 months, because firms needed time to arrange financing and plan new projects.
The bank held its rate, activity picked up in the tenth month, and inflation stayed under control. The illustrative lesson is that judging a policy before its response lag has run can lead to overreaction. The bank also published its reasoning, which helped households and businesses understand why the effect would take time.
Watch out
Common mistakes.
- Expecting an immediate result from a policy change, when the economy takes time to respond.
- Adding extra stimulus before the first has had time to work, which can cause overshooting and inflation.
- Assuming the lag is the same every time, when it varies with economic conditions, the type of policy and the confidence of households and businesses.
Questions
People also ask.
What is the difference between inside lag and outside lag?
The inside lag covers recognising, deciding and implementing a policy, while the outside lag, or response lag, is the time for the policy to affect the economy.
Why is monetary policy said to work with long lags?
Interest rate changes feed through banks, borrowing decisions and investment plans, which can take many months, and estimates vary widely between economies and over time.
How should a business allow for response lag?
By phasing its own initiatives, setting review dates beyond the typical delay and avoiding judgements based on the first few weeks of data.
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