Lags in Monetary Policy: Meaning, Nature and Criticisms

In this article we will discuss about:- 1. Meaning and Types of Lags in Monetary Policy 2. Nature of the Lag in Monetary Policy 3. Criticisms 4. Policy Implications.

Meaning and Types of Lags in Monetary Policy:

One of the limitations of monetary policy in countercyclical manner is the existence of time lags. It takes time for the monetary authority to realise the need for action and its recognition, and the taking of action and the effect of the action on economic activity.

Friedman defines “lag” as the timing relation between the resulting monetary series and resulting series of effects of monetary actions. According to him, monetary actions affect economic conditions only after a lag that is “both long and variable”. Friedman distinguishes among three basic lags: the recognition lag the administrative lag, and the operation lag.

These lags are explained as under:

1. The Recognition Lag:

It refers to the time between the development of a need for action and the recognition of that need by the monetary authority. It is difficult to know the occurrence of a turning point in a business cycle and recognise the need for action by the monetary authority.

Empirical evidence in the U.S. suggests that in the past the Federal Reserve Bank recognised the need for monetary action only three months after the trough in a business cycle and about six months after a boom had started. Thus the recognition has been longer at the peaks than at the troughs.

2. The Administrative Lag:

This relates to the period of time that occurs when the monetary authority recognises the need for action and the data on which action is actually taken. The length of the administrative lag (or decision or action lag) varies with the type of monetary policy being considered and the decision­ making process of the monetary authority.

Usually, this lag is very short. The administrative lag and the recognition lag taken together are termed as inside lags because they fall within the jurisdiction of monetary authority. Sometimes, it is difficult to distinguish between the two because the time between recognition of the need for action and the taking of action is so short that the administrative lag becomes the recognition lag.

3. The Operation Lag:

The operation lag (or the effects lag) refers to the period of time between the adoption of monetary policy and the final effect of that policy on the economic activity. For analytical convenience, this lag is divided into the intermediate lag and the outside lag.

(a) The intermediate lag relates to the moment at which action is taken by the monetary authority and the moment at which the economy is faced with changes in interest rates and the money supply through monetary action.

(b) The outside lag refers to the time involved between changes in interest rates, total reserves, credit rationing, etc., and their effects on aggregate spending, income and output of the economy.

The three lags are explained in Fig. 1 where the time lags are taken on the horizontal axis and aggregate income and output on the vertical axis. Starting from time T on the upper turning point of the business cycle, the period R shows the recognition lag, A the administrative lag and E the effect lag. In the effects lag, two alternative effect paths EP and EP₁ are shown along with changes in national income as a result of changes in monetary policy.

The curve V represents the movements in national income before the policy changes. When the effects lag EP operates with an expansionary monetary policy to control a downward movement of the business cycle, the curve Y represents the resultant movement in income and output. If the restrictive policy with the effects lag EP₁ is undertaken to control a boom, the resultant path of income is the curve Y₂.

Nature of the Lag in Monetary Policy:

According to Friedman, a lag is both long and variable which describes the timing relation between the money stock and economic activity. Strictly speaking, there are several lags in the effects of monetary action rather than the lag.

If the effect on national income of a single monetary change could be isolated, it would begin immediately, rise to a peak, then decline gradually, and not disappear fully for an indefinite time. Such effects of the change are distributed over a long period of time. Friedman calls this distribution lag rather than lag proper.

This is because monetary changes are never single and instantaneous. They consist of time sequence of changes whose effects accumulate and which are themselves in part the accumulated effect of other changes in the economy. Thus the concept of the lag is very complex, according to Friedman.

On the basis of empirical evidence, Friedman comes to the conclusion that peaks in the rate of the money stock precede reference cycles (economic activity series) by 16 months on the average; peaks in the deviation of the money stock from its long term trend precede reference cycle peaks by 5 months on the average; such peaks in the absolute level of the money stock precede reference peaks by less than 5 months and may even lag behind; peaks in the rate of change of income precede peaks in the stock of money, and probably follow peaks in the rate of change of the money stock.

Why is the Lag Long?

Friedman gives answer to this by explaining the transmission process from changes in the money stock to economic activity in which delays occur between the timing of action and the resultant effects. Suppose the central bank increases the stock of money by purchasing securities in the open market. Its first effect is to change the balance sheet or assets and liabilities structure of the community.

It tends to increase cash with people who will seek to purchase other types of financial assets. Consequently, the prices of such assets will rise. Sooner or later, the increased demand for assets will spread to equities, houses, durable producers goods, etc. In the process, the price rise will be reduced in magnitude as the demand spreads over a wide range of assets.

This transmission process will not be instantaneous. Rather, it will have a long time lag. First, the initial monetary action and its effects will take a long time to reach the whole range of assets. Second, the increased demand for assets will encourage producers to create more assets which will also take a long time. With the increase in asset prices, people will consume more services such as renting a house instead of purchasing it.

This will raise prices of services and interest rates. All this will raise expenditures in all directions. This process will entail a very long period of time. Friedman concludes that the lag between monetary change and its impact on the flow of income is expected to be very much longer than between monetary change and financial markets.

Why is the Lag Variable?

The main piece of empirical evidence on the variability of the lag is the variation from cycle to cycle in the estimated time interval between specified characteristics of the money stock series and reference cycle turning points.

The empirical findings of Friedman and Schwartz reveal that the lag is highly variable. They found that on the average of 18 cycles, peaks in the rate of change in the money stock precede peaks in economic activity by about 16 months; and troughs in the rate of change in the money stock precede troughs in economic activity by about 12 months. For individual cycles, the recorded lag varied between 6 and 29 months at peaks and between 4 and 22 months at troughs.

These are wide variations in lags which may be due to errors of measurement. But the errors of measurement largely cancel out in estimating the average lag. Given a particular length of lag, large variability in the lag simply means greater irregularity in length and timing of the resulting business cycles. At any one time, numerous disturbances affect the economic system through a variety of reaction mechanisms. If each part of the transmission mechanism has a “variable reaction time”, their combined effect would spread the ultimate effects. This keeps the lag highly variable.

Criticisms of Lags in Monetary Policy:

Prof. Culbertson does not agree with Friedman that a lag is both long and variable. He argues that there has been moderateness in economic fluctuations in the past which is a direct testimony against a long and variable lag. But Friedman has refuted his argument.

According to him, neither the length nor the variability of the average time interval between a disturbance and its effects is connected with the amplitude of the economic fluctuations produced by a given set of disturbances.

Some critics have pointed out that factors, other than monetary changes, also play an important role in explaining economic fluctuations. Fiscal policy in the form of tax rates and government expenditure influence business cycles and affect greatly on the length and variability of the lag.

Policy Implications of Lags in Monetary Policy:

The existence of long and variable lags in the effects of monetary changes has led Friedman to conclude that discretionary countercyclical policy aimed at economic stabilisation may be destabilising. These lags can intensify rather than mitigate cyclical fluctuations.

Let us explain Friedman’s view in detail:

Countercyclical monetary policy means “leaning against the prevailing economic winds”. It implies that the central bank follows an easy money policy in a recession and a tight money policy in a boom. Given the long length of the lags and their variability, the effects of an easy monetary policy to control a recession may lead to inflationary pressures. Similarly, a tight monetary policy to control a boom may lead to recessionary conditions due to time lags and their delayed effects.

According to Friedman, “We seldom in fact know which way the economic wind is blowing until several months after the event.” Due to unpredictability in forecasting of booms and recessions, and the length, variability and uncertainty of the time lags, a countercyclical monetary policy is destabilising rather than stabilising.

Since the implementation and effects of anti-cyclical monetary policy do not occur at the right time, they will add to the amplitude of the cycle and destabilize the economy. Friedman, therefore, favours an “automatic framework” of monetary policy in which the money supply increases at a steady and inflexible rate.

He gives two reasons in support of the automatic framework as against the discretionary monetary action. First, discretionary anti-cyclical monetary policy is often dominated by goals other than, and even contradictory to stabilisation, when the monetary authority adopts 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.

Friedman, therefore, calls for an end to discretion in monetary policy. In place of the judgement of monetary authority, he proposes that it should follow a fixed long-run rule: To increase the money supply at an annual fixed percentage rate regardless of current economic conditions. Set the money supply at a fixed rate and leave it to grow at that rate automatically.

Of course, such an automatic framework would not eliminate economic fluctuations, but it would at least prevent the economy from the perverse effects of delayed discretionary monetary action. Friedman is not rigid about any exact rate of increase in the money supply.

He suggests a rate in the neighbourhood of 3 to 4 per cent per year which closely approximates the economy’s past average annual rate of growth in real output. Such a stable growth rate of money supply will keep prices stable and allow the aggregate demand to grow with the growth in productive capacity of the economy.

It will thus increase employment and income. Any inflationary situation will be temporary because it will not receive an impetus by any increase in the money supply. Similarly, any recessionary tendency will be short-lived because the liquidity provided by the constant money supply will cause aggregate demand to expand.

Thus the automatic framework suggested by Friedman would remove uncertainties of forecasting economic fluctuations and the problems of time lags associated with discretionary countercyclical monetary policy. Fig. 2 illustrates the 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.

Criticisms of Policy Implications:

Culbertson does not agree with Friedman’s automatic policy framework to eliminate unpredictability and lag problems of a discretionary monetary policy. He opines that “the broad record of experience supports the view that anti-cyclical monetary debt management and fiscal .adjustments can be counted on to have their prominent direct effects within three to six months, soon enough that if they are undertaken moderately early in a cyclical phase they will not be destabilising”.

The Keynesians also do not concur with Friedman’s policy prescription to avoid the lag problems. They favour the use of monetary policy to control a boom, and supplementing monetary policy with fiscal policy to control a recession. Whichever policy is adopted, the lag problems and economic fluctuations cannot be completely eliminated.