What Is Response Lag?
Response lag, also known as impact lag, is the time it takes for monetary and fiscal policies, designed to smooth out the economic cycle or respond to an adverse economic event, to affect the economy once they have been implemented.
- The response lag is the time between when monetary and fiscal policies have been implemented and when the policies actually have an impact on the economy.
- Such policies are often instituted in response to a devastating economic effect, or to help support the economy at a certain point in the economic cycle.
- Response lag is one of the four policy delays that can make it challenging for policymakers to shore up the economy when it is struggling—along with recognition lag, decision lag, and implementation lag.
Understanding Response Lag
Response lag is one of four policy lags that can make it hard for policymakers to improve the performance of the economy; policy lags can even destabilize the economy. Because of recognition lag, it may take months or even years before politicians acknowledge that there has been an economic shock or a structural change in the economy. Then there is decision lag, with policymakers debating the appropriate policy response, followed by implementation lag before any fiscal or monetary policy action is taken.
Response lag comes last. After officials have recognized a macroeconomics issue they want to address, decided on the desired policy, and actually implemented the policy, it then takes time for the policy measures themselves, such as an injection of credit into the financial system or the issuance of stimulus payments, to work their way through the economy an ultimately have an effect on the economic variables of interest.
Response lag occurs because any monetary fiscal policy, once implemented, must then work through a series of transactions that occur between market participants. Each of these transactions takes time, and businesses, consumers, and investors along the chain of transactions may wait for some time before completing the next transaction. Eventually, once all the necessary transactions take place, the outcome of the policy may be observed.
For example, during periods of economic distress, the direct issuance of stimulus checks to taxpayers has become a popular gimmick of fiscal policy. However, once the policy has been implemented, and the checks are in taxpayers' hands, several more steps need to occur before the policy can have its desired stimulatory effect. Taxpayers need to cash or deposit the checks with a financial service provider, then they need to spend the money they get on goods and services. Therefore, stimulus policies depend heavily on the multiplier effect: the businesses where taxpayers have spent their stimulus money need to in turn deposit the money in their banks and then spend it on wages, raw materials, or other goods purchased from other businesses.
Because all economic action necessarily takes place over time, this chain of transactions may take a while. The process may be delayed if, at any step along this chain of transactions, the holders of the stimulus money hang on to it for a while as savings rather than spending it on. Only once the new stimulus money has circulated throughout the economy can the full effect of the policy be felt and observed by policymakers. The time interval between this point and the point of implementation (the mailing of the checks) is the response lag of the stimulus policy.
Interest Rates and Response Lag
In the popular imagination, central banks can control the economy at will by manipulating the money supply and interest rates. In reality, it is difficult to determine how effective monetary policy has been, never mind knowing how tight monetary policy should be.
When the Federal Reserve cuts the federal funds rate, it can take 18 months before there is any evidence of that changes’ impact, and central banks can find themselves pushing on a string. This inability to fine-tune the economy, with the aim of evening out business cycles, is perhaps why many tightening cycles in the Fed's history have been followed by a recession or depression.
There are many reasons for the response lag on interest rate cuts. Homeowners with fixed-rate mortgages cannot take advantage of interest rate cuts until their loans come up for refinancing, and banks often delay passing on bank rate cuts to consumers. Businesses and consumers may also wait to see if a rate change is temporary or permanent before making new investments. And if lower interest rates weaken the currency, it can take months before new export orders are placed.
Response Lag on Other Economic Measures
The impact of tax cuts or changes in government spending is more immediate—although they also affect the long-run trend rate of economic growth. But fiscal policies still take months to have any effect on the economy. For example, while Trump’s tax reform went into effect in January 2018, it was for the 2018 tax year, meaning the impact was not felt until the spring of 2019 when Americans filed their 2018 taxes.
Other policies encourage saving more to improve productivity. A higher savings rate hits current consumption but leads to more investment and higher living standards in the long run—according to the Solow residual. Quantitative easing has been criticized because it does little to encourage real capital investment which would improve the productive capacity of the economy.