Friday, December 19, 2008

Time Lags in Economics

Time lags play an important role in the effectiveness of economic policy. It is estimated that interest rate cuts can take upto 18 months to have their full effect. This means that the rate cuts of the past few months, may not have their full effect until mid 2010. Of course, by then the economy may have recovered from the recession. It is the same with fiscal policy, if the government plans to increase spending e.g. bring spending plans forward it can still take several months for the fiscal stimulus to kick in.

Why is there A Time Lag for interest rate cuts?
  • Fixed rate mortgages. Many on fixed rate mortgages are effectively insulated from the current rate cuts. When they come to remortgage in 1-2 years time, they may be able to remortgage to a lower rate. But, there disposable income is not being influenced by current rate cuts.
  • Confidence. Just because rates are lower doesn't mean firms rush out to invest in building new factories. They will give a greater weighting to growth and expectations of future growth. Therefore, it will take time before they respond to lower rates by deciding to invest.
  • Banks not passing rate cut on. Banks are often slow to pass the rate cuts on to consumers. Also, they may not pass the full rate cut on anyway.
  • Effect of depreciation. Lower rates have cause the Pound to fall. A lower value of the pound should make UK exports cheaper. In the short term, demand is usually inelastic. But, over time, demand will become more elastic and the exchange rate effect will be greater.
Problems of Time Lags
  • The problem with time lags is that it makes any attempts at reflating the economy less effective. The UK economy is in recession - the Bank has cut interest rates and the government has cut taxes. However, if they don't have any real effect for 9-12 months, it means the recession will last for a long time. Unemployment will rise and there is nothing which can be done about it.
  • The problem is that we now be facing the impact of the decision to raise rates from 12-18 months ago.
  • The other danger is that the government may go too far in reflating the economy, so in 12 months time we could face the prospect of inflationary pressure because of the current expansion. I don't really think inflation is a problem at the moment, but, it has often been a criticism levelled at fiscal policy.
  • One analogy of fiscal policy is that it is like driving a car, where you can only look out of the back window (economists can only see the past not the future)
  • Then when you try to steer the car, it takes 5 minutes (time Lag) for the steering wheel to change the direction of the car. Therefore, for a left handed turn you can end up moving the car to the right and therefore crash.

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