Lag of Monetary Policy

Consider monetary policy. There may be a lag of several quarters between a cut in interest rates and the response of aggregate demand. For example, a drop in interest rates is supposed to raise the cost of foreign goods because of depreciation; however, even if the exchange rate moves in the right direction at once, it may take time for foreign producers to increase the prices of their exports. Further, even after prices change, some time may elapse before domestic buyers switch from imported products to domestic products.

Hence, with regard to monetary policy, the second lag, implementation lag, may be short but the third lag, impact lag, may be large. For example, the Bank of Japan usually holds policy decision meetings twice a month to discuss monetary policy. These meetings are the main opportunity for the Bank to change the target interest rate or money supply. Thus, the Bank may change the policy promptly if necessary. However, a change in the target interest rate affects the investment of firms and the consumption of households gradually. Consequently, the purpose of a country- cyclical policy may take some time to achieve.

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