CENTRAL BANKING: LAGS IN MONETARY POLICY
In this blog, we will discuss one important topic from CAIIB Syllabus i.e. Lags in Monetary policy for 2023 Exams.
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Now, let us begin with the main topic of the blog. The topic: Lags in Monetary Policy have been taken from the Module – C: Monetary Policy and Credit Policy of Central Banking Syllabus 2023.
First, we need to understand the meaning of Monetary policy:
Monetary policy is the control of the amount of money available in the economy and the channels through which new money is supplied.
Economic statistics such as:
- gross domestic product (GDP),
- inflation rates, and
- industry-specific growth rates and
- sector-specific growth rates
influence monetary policy strategy.
The central bank controls the money availability as it –
- Can revise the interest rates it charges for lending money to national banks. As rates rise or fall, financial institutions adjust rates for their customers, such as businesses or home buyers.
- In addition, it can buy or sell government bonds and revise the amount of cash banks are required to hold as reserves.
There are 2 types of monetary policies:
Monetary policy is seen as either expansionary or contractionary depending on the level of growth or stagnation in the economy.
- Contractionary policy raises interest rates and reduces the remaining money supply to slow growth and reduce inflation, when the prices of goods and services in the economy rise and reduce the purchasing power of money.
- Expansionary policy: In times of slowdown or recession, an expansionary policy boosts economic activity. As interest rates fall, savings become less attractive and consumer spending and borrowing rise.
But like all things or tools monetary policy also have some limitations:
One of the limitations of monetary policy in a countercyclical way is the existence of time lags. It takes time for the monetary authority to realize the need for the action and its recognition and acceptance of the action and the impact of the action on economic activity.
Lag has been defined as the time relationship between the resulting monetary series and the resulting series of effects of monetary actions. Accordingly, monetary actions affect economic conditions only after a lag, which is “long and variable”.
The following points highlight 5 main types of lags in monetary policy.
The delays are:
- Data delay
- Recognition delay
- Legislative delay
- Transmission delay
- Effectiveness delay.
This refers to the period of time that occurs when the monetary authority recognizes the need for action and the data on the basis of which the action is actually taken.
- The length of the administrative delay (also called as decision-making/negotiation delay) varies according to the type of monetary policy under consideration and the monetary authority’s decision-making process.
- Usually this delay is very short.
- Administrative delays and recognition delays are together called internal delays because they fall under the jurisdiction of the monetary authority.
- Sometimes it is difficult to distinguish between the two, because the time between recognizing the need for action and taking action is so short that the administrative delay becomes a recognition delay.
Data Delay: At first glance, policymakers do not know exactly what is happening in the economy when this happens. An economic change that begins at the beginning of a month usually becomes apparent by the middle of the following month. The data delay is therefore approx. of 1.5 months.
Recognition Delay: It refers to the time between the development of a need for action and the recognition of that need by a monetary authority. It is difficult to recognize that there has been a turn in the business cycle and recognize the need for action by the monetary authority. Empirical evidence had suggested that in the past, Central Banks recognized the need for monetary action only 3 months after a downturn in the business cycle and about 6 months after the boom began. Thus, recognition was longer on peaks than on troughs.
Data for real economic variables are required over time as government agencies receive more complete information. There is a detection lag of at least 2 months because no policymaker pays much attention to reversals in data that occur only one month.
Legislative Delay: Unlike fiscal policy changes, which occur only once a year, monetary policy changes occur at least twice a year, or in some countries 3 to 4 times a year. An important advantage of monetary policy is therefore a short legislative delay. Monetary policy changes can be enacted quickly. But the legislative delay is a big weakness.
Transmission Delay: The transmission of the monetary policy describes how changes made by the Reserve Bank in the setting of its monetary policy are passed through to economic activity and inflation. The process is complex and there is a great deal of uncertainty about the timing and magnitude of the impact on the economy.
In a simplified way, the transfer can be summarized in 2 phases.
- Changes in monetary policy affect interest rates in the economy.
- Changes in interest rates affect economic activity and inflation.
The transmission lag is the time interval between a policy decision and the subsequent change in policy instruments. Transmission lag is presents more serious obstacle for fiscal policy than for monetary policy. Due to frequent changes in the bank rate, there is no transmission delay in the case of monetary policy.
Delay in Effectiveness: Implementation lag describes the time that elapses between the occurrence of an economic problem and the implementation of a policy to affect the action. An implementation may be delayed due to a specific protocol that may increase the implementation time.
The most important lag in monetary policy refers to the length of time it takes for an acceleration or deceleration of the money supply to affect real output. The effect delay is long and variable, making the multiplier value uncertain.
So, this was all about the delay that happens in the monetary policy implementation. You can also find other notes on CAIIB’s subjects such as ABM, BFM, ABFM, BRBL, Central Banking & other elective papers for upcoming CAIIB Examinations.
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