What Is a Response Lag?
Response lag, also known as impact lag, is the time it takes for corrective 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 break 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 make it hard for policymakers to improve the performance of the economy—and can even destabilize it. 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.
How Response Lag Works
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.