In economics we often see a delay between an economic action and a consequence. This is known as a time lag.
An impact of time lags is that the effect of policy may be more difficult to quantify because it takes a period of time to actually occur.
Example of Time Lag – Interest rate Changes.
If we cut interest rates, we would expect a rise in investment and consumer spending. This is because lower interest rates make it cheaper to borrow and also make it less attractive to save. Lower interest rates should lead to higher aggregate demand.
However, there may be time lags for a number of reasons.
- Fixed interest rates for borrowing and saving. Consumers may have a fixed rate mortgage. This means interest payments are fixed for say 2 years. Therefore, it may be over a year before homeowners actually have to face a higher interest rate.
- Starting projects. If a firm has started an investment project, they are unlikely to stop in the middle because of an increase in interest rates. Once started they will continue to invest whatever happens to interest rates. However, over time, the higher interest rates may prevent future investment projects taking time.
- Knowledge. Consumers don’t have perfect knowledge. They may not check interest rates every month, but only become aware after a certain time.
- People may wait to see if the interest rate change is temporary or permanent.
- Commercial banks may delay passing on the base rate cut onto consumers.
Importance of Time Lags
Time lags can make policy decisions more difficult. It is estimated interest rate changes take up to 18 months to have the full effect. This means monetary policy needs to try and predict the state of the economy for upto 18 months ahead. In practise this is difficult.
Therefore, time lags tend to reduce the effectiveness of monetary and fiscal policy, especially for trying to ‘fine tune’ the economy.