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Definition of the Lag Effect:
The lag effect
is the potential ineffectiveness in fiscal policy due to the time it takes to recognize an issue, implement the appropriate policy, and affect the economy.
In theory, the government could effectively use fiscal policy to manage the economy if it knew exactly what the fiscal multiplier was for a given policy and if it could apply the policy immediately. A policy could be implemented to generate the exact increase or decrease in the aggregate demand needed to bring the economy to the long-run equilibrium.
Unfortunately, there is a time lag between the recognition of a problem and the effective management of the economy. The lag could be years. By the time a policy has been put into practice, the economy has moved on, and the policy may be counterproductive. Economists frequently disagree on whether the economy is approaching a recession, or whether inflationary pressures are short-term or long-term. After recognition, it takes time to agree on the best course of action.
For example, assume everyone agrees that the economy is in a recession. Some in Congress may believe the economy is showing signs of recovering on its own and would promote doing nothing to stimulate the economy. Others may favor tax cuts to stimulate the economy, while others would push for increases in government spending. Getting economists and the government leaders to agree on a course of action may take months. Compromises may be made which dilute the policy. By the time a fiscal policy is enacted, the economy may have recovered. The stimulus may in fact be counter-productive and inflationary! It is also possible that the recession worsens, and the watered-down policy may prove insufficient. Finally, there is an operational lag. Even if a new policy is passed, it takes time to implement. Consumers must “feel” wealthier to spend. Businesses must recognize the need to invest before they actually invest. This process may take many months.
Generally, economists prefer monetary policy for minor changes to the economy, as opposed to fiscal policy enacted by the government, in part because monetary policy’s lag effect is shorter. Most economists believe that changes in fiscal policy by the federal government should be implemented when dramatic action is needed.
Dig Deeper With These Free Lessons:
Fiscal Policy - Managing an Economy by Taxing and Spending
Monetary Policy - The Power of an Interest Rate
Aggregate Supply and Demand - Macroeconomic Equilibrium
Causes of Inflation