September 4, 2015 

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PAYMENT FLOW: In the circular flow, the clockwise transfer of money in payment for the counter-clockwise physical flow of goods and services. The payment flow is the monetary payment for goods and services received by the household sector from the business sector through product markets and the monetary payment for resource services obtained by the business sector from the household sector through factor markets.

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Time lags that occur between the onset of an economic problem and the full impact of the policy intended to correct the problem. Policy lags come in two broad categories--inside lag (getting the policy activated) and outside lag (the subsequent impact of the policy). The three specific inside lags are recognition lag, decision lag, and implementation lag. The one specific outside lag is termed impact lag. Policy lags can reduce the effectiveness of business-cycle stabilization policies and can even destabilize the economy. Policy lags, especially inside lags, are often different for monetary policy than for fiscal policy.
Policy lags arise because government actions are not instantaneous. The use of any stabilization policy encounters time lags between the onset of an economic problem, such as a business-cycle contraction or the onset of inflation, and the full impact of the policy designed to correct the problem. For example, should a business-cycle contraction hit the economy on January 1st, stabilization policy cannot correct the problem by January 2nd. The use of any stabilization policy, especially fiscal policy and monetary policy, takes time to work through the system.

Policy lags are commonly divided between inside lag and outside lag. Let's take a look at each.

Inside Lag

Inside lag is the time it takes between the actual onset of a problem and the launching of the corrective action by government. The wheels of government often spin slowly and deliberately. Three types of inside lag occur.
  • Recognition Lag: Before any policy action can be pursued, the existence of the actual problem must be identified. It takes time to collect and analyze economic data. Unemployment and inflation data are usually available only a month or so after the fact. That is, the unemployment rate for January is usually available in February. Production and income data are reported quarterly and have an even longer lag. Gross production data for January, February, and March is seldom available until May. Once data are obtained, it must be analyzed and evaluated to ensure that it reflects the onset of an actual problem, such as a business-cycle contraction. This often requires several months of data to document an actual trend and determine that it is not just a temporary statistical aberration.

  • Decision Lag: Once government policy makers have identified the problem, they need to decide on a suitable course of action, then pass whatever legislation, laws, or administrative rules are necessary. Often this requires an act of Congress, signed into law by the President. Congress is bound to debate the appropriate policy, make amendments, and promote particular political interests along the way. For example, if a business-cycle contraction is identified, Congress is likely to debate over an expansionary fiscal policy use of increased government spending or decreased taxes. But will the spending go for purchases or transfer payments? If it goes for purchases, then what types of goods or services are purchased? If taxes are decreased, which taxes are cut and who receives the extra income? These decisions could take days, weeks, or months.

  • Implementation Lag: After a particular policy has been selected, steps then need to be taken to implement the policy. For any change in spending, the appropriate government agencies need to be contacted. More often than not, this involves a change in budget appropriations. The affected agencies then need to actually make changes in their spending. The act of spending is not instantaneous. Most agencies require competitive bids to identify product suppliers before they can make the expenditures. Even the employment, then subsequent payment, of additional workers takes time. The implementation of fiscal and monetary policy is also likely to take weeks if not months.
Inside lags are likely to take several months. A best case scenario involves at least two months. One month to recognize the problem and another month to select and implement the appropriation policy. A more likely scenario is three to six months of inside lags.


The outside lag is the time it takes after a policy is selected and implemented by appropriate government entities, before it works its magic on the economy. Such magic is not instantaneous. The principal outside lag is termed the impact lag.
  • Impact Lag: This lag is the time it takes any change initiated by a government policy to impact the producers and consumers in the economy. A key part of the impact lag is the multiplier. An initial change in government spending, taxes, the money supply, interest rates must work through the economy, triggering changes in production and income, which induces changes in consumption, which causes more changes in production and income, which induces further changes in consumption. Each "round" of changes (consumption expenditures on production that are induced income) is likely to take a month or two. Several rounds are needed (six to ten or more) before the bulk of this impact is realized. An impact lag of one to two years is not uncommon.

Monetary versus Fiscal

Both monetary and fiscal policy encounter time lags. The outside, impact lag for each is very much the same. Once the policies are activated, then the economy works through several rounds of production, income, and consumption before results are realized.

However, the story is a little different for inside lags. While the recognition lag is much the same regardless of the policy used, the decision and implementation lags tend to be different for monetary versus fiscal policy.

  • Monetary Policy: The decision lag for monetary policy tends to be relatively short. Monetary policy decisions are made by the Federal Open Market Committee of the Federal Reserve System, a small group consisting of 12 members and an relatively powerful chairman. Monetary policy is their primary task. This committee meets every six weeks or sooner if needed usually comes to a policy decision when faced with a business-cycle problem with very little delay.

    The implementation lag is also relatively short. Policy decisions are implemented by a special branch of the Federal Reserve System devoted to this task. Once a policy action is identified, then the implementation steps are begun almost immediately (often by the end of the day). And because monetary policy works through financial markets (which tend to operate quickly), implementation is completed in short order.

  • Fiscal Policy: The decision lag for fiscal policy tends to be relatively long. Fiscal policy decisions are made by Congress and the President, more often than not, literally involving and act of Congress signed into law by the President. Because Congress represents diverse interests, finding a fiscal policy that is acceptable to a majority can take time. And hopefully this decision is acceptable to the President, as well. If not, then the decision making process continues, and the decision lag continues.

    The implementation lag also tends to be relatively log. Any changes in government spending or taxes need to work through the government agencies and bureaucracies before than are implemented. Bureaucracies, by their very nature, are slow to act as they make sure that necessary rules and procedures are followed. But this tends to lengthen the time needed to implement fiscal policy.

Destabilizing Policies

The goal of stabilization policies is to stabilize the business cycle, to counter contractions and expansions. However, policy lags can actually make stabilization policies destabilizing. That is, they can worsen the ups and downs of the business cycle.

For example, if the impact of expansionary fiscal policy is not seen for a year or more after the onset of a business-cycle contraction, then the stimulation might occur during the ensuing expansion, which can then overstimulate the economy and cause inflation.

Alternatively, the impact of contractionary monetary policy designed to reduce inflation created during an expansion might not occur until the onset of an subsequent contraction. In both cases, the resulting policy is not counter-cyclical, but pro-cyclical. The policies reinforce and thus destabilize the business cycle.


Recommended Citation:

POLICY LAGS, AmosWEB Encyclonomic WEB*pedia,, AmosWEB LLC, 2000-2015. [Accessed: September 4, 2015].

Check Out These Related Terms...

     | recognition lag | decision lag | implementation lag | impact lag | automatic stabilizers |

Or For A Little Background...

     | aggregate market | Keynesian model | business cycles | monetary policy | fiscal policy | expansionary monetary policy | expansionary fiscal policy | contractionary monetary policy | contractionary fiscal policy |

And For Further Study...

     | recessionary gap | inflationary gap | recessionary gap, Keynesian model | inflationary gap, Keynesian model | multiplier | accelerator principle | paradox of thrift | injections-leakages model |

Related Websites (Will Open in New Window)...

     | Federal Reserve System | White House Office of Management and Budget | | Congressional Budget Office |

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