Saturday, December 20, 2008

Why Lags Exist?

In economics, lags mean a delay. We often hear about recognition lags, implementation lags & effect lags but what exactly are they?

Recognition lags: Time taken by policymakers & economists to realise that something has actually happened in the economy

Implementation lags: Time taken for a policy to be instituted

Effect lags: Time taken before the effect of the policies can be really seen in economy

Why recognition lags could happen?

(1) New data is not released on daily basis. It takes time for the statisticians in ONS (Office for National Statistics) to collect, run the data, analyse & produce a report on all those macroeconomic variables. At the moment of writing, only the data of real GDP for the third quarter of 2008 (July-September) is available instead of December. On the other hand, number of people claiming jobseeker’s allowance while is reported every month still need about 2 weeks to report the data. The same goes for inflation measures. As such, we say that problems could have exist months ago & economists are just too slow in response

(2) Policymakers are ‘too careful’. Even if those policymakers have series of data for e.g. real GDP for 3 consecutive quarters which are declining, they may still reluctant to admit that the economy is ailing. They will believe that ‘it’s not more than a temporary fall’ since the economy is correcting itself. They will not believe that the economy is steering towards recession until the day where everyone is out of job. Similarly, the financial crisis is said to have happened in the 4th quarter of 2007. The early symptom in UK is where Northern Rock which went under administration & then nationalised. In US, economists argued that the government is relatively slow to throw in the bailout. It should be done much earlier rather than watching those financial institutions suffer larger loss such as AIG, Bear Sterns, Freddie Mac & Fannie Mae

Why implementation lags could happen?

(1) Bureaucracies. This is often associated with fiscal policy. Fiscal policy is the manipulation of government spending & level of taxation to influence the movement of AD. Say, in the period of slowdown government would pursue expansionary fiscal policy by increasing public spending & reduce level of tax. But in pursuing more spending, its legislation will have to go through various layers of administration. Also it may take quite a long time to secure suitable sites & planning permission. This may take from months to years

(2) Tax is tabled annually. On the other hand, tax changes whether direct tax e.g. income & corporation tax or indirect tax like VAT (value added tax) are usually announced in the annual budget. There is often a further time lag before they come into effect, although changes in taxes on addictive goods such as cigarette & alcohol and necessities may be more immediate

Why effect lags could happen?

(1) Some people on fixed rate mortgages. In the early 2000s, interest rate was standing at 3%. But over the years, due to rising inflation no thanks to property market boom, MPC had continuously adjusted the base rates upward. It was standing at 5.75% in September 2007. Owing this, many borrowers had begun switching from variable rate mortgages to fixed rate mortgages to avoid paying more. As such it is said that any cut in interest rates will not affect the consumption pattern of these people, not until at least the period of 18 months. Therefore, although the interest rates had been slashed to 2% in December, its impact may not feed through the whole economy until June 2010

(2) People & firms are cautious in spending. Even if interest rate is lower, it may still not affect those people taking variable rate mortgages. This is because consumers will look at broader aspects before deciding to take up any large commitments. They are concern about the health of UK economy, how severe are job losses, how much prices of house has fall, will prices fall further etc. For firms, interest rate cut will not cause them to immediately spend onto new capital goods, machineries or building new factories. Outlook of consumer confidence is very important as it will determine the demand for goods & services they produce

(3) Banks slow in passing rate cut. Financial institutions have been condemned for notoriously good at raising interest rates, when BOE or Fed raise it but slow in response to rate cut. This is because, increase in base rates could mean greater profitability for banks & vice versa. Even so, they may not pass on the full rate cut. For e.g. BOE slashed interest rates by 75 bps, but banks only reduce it by 25bps. This is very apparent in the current period, where banks are more keen in regaining some of the losses & also to build up their lending funds once again by maintain higher rates. This s also called recapitalisation

(4) Exports are inelastic in short run. Cut in interest rates will cause depreciation depending on how large is the cut. Wealthy foreigners, hedge funds & investment trusts will withdraw money from UK & park their money elsewhere which gives better return in interest rates. This is one of the major reasons as to why pound is fast depreciating against many other major currencies, & is set to be on par with Euro. As pound drops in value, buying from UK should be much cheaper & this will boost its export. However, demand for exports will often be inelastic in the short run e.g. contracts have been signed earlier & firms couldn’t adjust the amount of goods produce. But in long run, the positive effects onto current account will be seen assuming that PEDX + PEDM > 1

(5) Job creations gradually expand. It takes time for the whole economy to heal, which actually work through the multiplier effect. Firstly, it took ages for the government to kickstart the construction of schools, hospitals etc. Many new jobs are created in the first round. When more people are in employment, there will be more spending into the economy. Firms now face greater demand for their goods & services, thus hire more people. In the second round, private consumption is expected to be greater & this continues. Also, it has external benefits to firms as now they can invest more. All these lead to rebound of economy. But having said so, it is not done overnight

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