MATRIC NUMBER: 19/77JA037

NAME: AREMU HAMMED

ISOLA
LEVEL: 300
COURSE TITLE: APPLIED
MONETARY ECONOMICS
COUSRE CODE: ECN 315
PURPOSE: ASSIGNMENT
LECTURER IN CHARGE :
DR.AKANBI
BASICS OF MONETARY POLICY
Monetary policy functions as a set of instructions implemented by the central
authority. The central authority sets the goals of monetary policy, which strives to
maximize employment levels, stabilize prices and maintain moderate levels of
long-term rates of interest. They uses monetary policy to control and moderate
the volume of money, as well as credit and interest rates. It uses these as vehicles
to influence employment levels, manufacturing output and general price levels.
TIME LAGS
Time lag refers to the delay between the implementation of monetary policy
measures and the effects of those measures on the economy. Time lag in
monetary policies is very high, this is because the economy takes a long period
before it responds to changes in monetary policies.
CAUSES OF TIME LAGS
As an example of a time lag in action, the central authority may cut interest rates,
but it will take time to see these cuts reflected in the economy for the following
reasons. First, homeowners with fixed-rate mortgages will not be able to take
advantage of interest rate cuts until their loans come up for refinancing, which
may take one to two years. During these two years, lower interest rates have not
made any difference to the amount of disposable income for this group of
individuals.
Additionally, consumers and businesses may lack confidence in the economy, so
even if interest rates become lower, they will look at the probability of future
growth prospects before choosing to take advantage of the lower interest rates.
Then, banks may not pass the full interest rate cut on to consumers, and any cuts
they do pass on will happen slowly.
Lastly, if the value of the naira falls, this would make exports cheaper for other
countries; however, other countries usually schedule orders in advance for
several months or more and so will not benefit from the change in the naira's
value. Ultimately, the time lag has prevented this monetary policy from having
any benefit for the economy in the near-term future.
One of the biggest issues with time lags is that they render attempts to improve
the economy less effective. For example, if the economy experiences a recession
the central authority enforces a new monetary policy decision to cut interest
rates, and the government enforces a new fiscal policy to cut taxes, the economy
may not see any evidence of real effects for nine to 12 months. During this time,
unemployment may rise, which becomes difficult to remedy.
Conversely, another problem happens when the government is too aggressive in
its efforts to stimulate the economy and then creates a situation where the next
12 months bring about inflation because of the current expansion.

HOW TIME LAGS LIMITS THE EFFECTIVENESS OF MONETARY POLICY

One of the limitations of monetary policy in is the existence of time lags. It takes
time for the monetary authority to realize the need for action and its recognition,
and the taking of action and the effect of the action on economic activity.
FRIEDMAN defines “lag” as the timing relation between the resulting monetary
series and resulting series of effects of monetary actions. According to him,
monetary actions affect economic conditions only after a lag that is “both long
and variable”. Friedman distinguishes among three basic lags: the recognition lag,
the administrative lag, and the operation lag.
These lags are explained as under:
1. The Recognition Lag:
It refers to the time between the development of a need for action and the
recognition of that need by the monetary authority. It is difficult to know the
occurrence of a turning point in a business cycle and recognize the need for action
by the monetary authority. Empirical evidence in the U.S. suggests that in the past
the Federal Reserve Bank recognized the need for monetary action only three
months after the trough in a business cycle and about six months after a boom
had started. Thus the recognition has been longer at the peaks than at the
troughs.

2. The Administrative Lag:

This relates to the period of time that occurs when the monetary authority
recognizes the need for action and the data on which action is actually taken. The
length of the administrative lag (or decision or action lag) varies with the type of
monetary policy being considered and the decision making process of the
monetary authority. Usually, this lag is very short. The administrative lag and the
recognition lag taken together are termed as inside lags because they fall within
the jurisdiction of monetary authority. Sometimes, it is difficult to distinguish
between the two because the time between recognition of the need for action
and the taking of action is so short that the administrative lag becomes the
recognition lag.

3. The Operation Lag:

The operation lag (or the effects lag) refers to the period of time between the
adoption of monetary policy and the final effect of that policy on the economic
activity. For analytical convenience, this lag is divided into the intermediate lag
and the outside lag.
(a) The intermediate lag relates to the moment at which action is taken by the
monetary authority and the moment at which the economy is faced with changes
in interest rates and the money supply through monetary actions.
(b) The outside lag refers to the time involved between changes in interest rates,
total reserves, credit rationing, etc., and their effects on aggregate spending,
income and output of the economy.
The three lags are explained in Fig. 1 where the time lags are taken on the
horizontal axis and aggregate income and output on the vertical axis. Starting
from time T on the upper turning point of the business cycle, the period R shows
the recognition lag, A the administrative lag and E the effect lag. In the effects lag,
two alternative effect paths EP and EP1 are shown along with changes in national
income as a result of changes in monetary policy.
The curve V represents the movements in national income before the policy
changes. When the effects lag EP operates with an expansionary monetary policy
to control a downward movement of the business cycle, the curve Y represents
the resultant movement in income and output. If the restrictive policy with the
effects lag EP1 is undertaken to control a boom, the resultant path of income is
the curve Y2.
EFFECT OF TIME LAGS IN MONETARY POLICY
The time lag in monetary policy can have several effects:
1. Delayed impact of policy actions: The effects of policy actions may not be felt
immediately due to the recognition, implementation, and transmission lags. This
delay can result in a policy that is ineffective in achieving its intended outcome.
2. Inflationary pressure or recession: A long recognition lag can lead to an
incorrect assessment of economic conditions that may result in an inappropriate
policy response. This can lead to inflationary pressure or a recession.
3. Uncertainty and volatility in financial markets: When there is a long delay in
policy implementation, markets might become uncertain, leading to increased
volatility.
4. Unintended consequences: The prolonged time lag in policy implementation
and transmission can result in unexpected outcomes. For example, an
expansionary policy meant to stimulate economic growth may end up causing
inflation in the future.

ECONOMIC UNCERTAINTIES

Economic uncertainty refers to a situation in which the future economic

environment is difficult to predict, and there is a high degree of risk or unknowns
involved. This can be caused by a variety of factors, including political instability,
changes in government policies, natural disasters, and market fluctuations.
Economic uncertainties refer to a lack of predictable and stable economic
conditions, which can cause fluctuations in economic indicators such as economic
growth, inflation, interest rates, and employment. This can arise due to various
factors such as market changes, political instability, technological advances, and
other external factors that are beyond the control of government policymakers.
Economic uncertainties can make it difficult to develop sound economic policies,
and it can lead to increased risk and uncertainty for businesses, investors, and
individuals.

CAUSES OF ECONOMIC UNCERTAINTIES

There are several causes of economic uncertainties in monetindividuals
1. Global Economic Conditions: Global events such as trade wars, political
instability, and economic downturns can have significant impacts on different
economies, which can affect monetary policies.
2. Shifts in market expectations: Shifts in market expectations can lead to
fluctuations in financial markets and the economy, which can raise uncertainties
that policymakers must address.
3. Policy Misjudgment: There can be errors in policymaking that lead to economic
uncertainties, including mistakes on the timing and magnitude of interest rate
changes, or errors in economic forecasting.
4. Supply side shocks: Disruptions in supply chains, natural disasters, and
pandemics can cause supply side shocks that can lead to economic uncertainties.
5. Unexpected events: Unexpected events such as black swan events that are
hard to predict can lead to economic uncertainties and create challenges for
policymakers.
EFFETS OF ECONOMIC UNCERTAINTIES ON MONETARY POLICY
Economic uncertainties can have several effects on monetary policy:
1. More cautious policymaking: Economic uncertainties can lead to more
cautious policymaking where policymakers may be hesitant to make significant
changes to monetary policy due to the potential risks and unpredictability of the
economy.
2. Delayed policy action: Economic uncertainties may cause policymakers to
delay making a decision on monetary policy until they have a clearer picture of
the direction of the economy.
3. Increased volatility: Economic uncertainties can create increased volatility in
financial markets as investors may react strongly to any news or developments
that could impact the economy and monetary policy.
4. Ineffective policy changes: Economic uncertainties can also make it difficult for
policymakers to accurately determine the appropriate policy changes, leading to
ineffective policy decisions.