Read this article to learn about the effectiveness of monetary policy in general (lags).

The effectiveness of monetary policy in general is attaining its objectives depends upon a good number of factors, especially on the nature of lags involved like the time lag and also on the activities of non-financial intermediaries in recent times; apart from the in-built limitations of macroeconomic monetary policy and the limitations inherent in the use of individual tools or instruments separately.

Absence of time lag, that is, no time should be lost between the need for action and the action taken. Similarly, there should be no time gap between the need for taking action and recognition of the need for taking action.

But in actual practice the actions of monetary authorities are not so prompt that no time lapses between the need for action, its recognition and the actual action taken. The effects of monetary policy or actions taken are not instantaneous but are subject to time lags. These lags primarily are: recognition lag, action lag, inside lag, outside lag, etc.


Recognition lag implies the time to recognize that the economy has changed in such a way as to require a change in the existing policy. Once the need for a change in policy is recognized, sometime must elapse before suitable action is taken called the action lag, which may again depend upon a number of factors. The total effect or sum of recognition lag and action lag is called the inside lag.

The inside lag is influenced by policy tradeoffs and priorities, as well as by the speed of data collection and analysis, administrative factors and other such factors. Once the policy is changed some additional time must lapse before the changes in the policy work, their way through the system and manifest themselves in changing the aggregate income, output or employment.

There is no agreement amongst economists about the time dimensions of these lags. For example, it is possible that an economy which is in equilibrium is disturbed in time too, its recognition takes place in time t1, the action is taken in time t2 but the effects of action take time to work themselves out say in t3 and so on.

Non-Bank Financial Intermediaries:

Gurley and Shaw had broken new ground in the USA by bringing forth the significance of NFI (non-banking financial intermediaries) and their activities and their influence on the real variables of the economic system as well as on the banking system. They had anticipated the Radcliffe approach in deviating from the conventional doctrine which distinguishes between banks and NFI and observed that both types of financial institutions created financial claims and engage in multiple creation of their liabilities in relation to any one class of asset that they might hold.


There are, however, important differences in the role of banks and intermediaries in the process of credit creation. The time involved in the process of credit creation by banks is much shorter than in the case of NFI, besides credit creation by the NFI is subject to more leakages of important nature than by banks. The NFI activities cause a serious threat to monetary policy and may even weaken its efficiency.

The introduction of the NFI with a financial asset which is a close substitute for money increases the interest-elasticity of the demand for money and so impairs the effectiveness of monetary policy. One great significant feature of the Gurley-Shaw approach is that it departs from the conventional treatment of the banking system as the ‘Cinderella’ of monetary policy.

‘Financial intermediaries are divided into two-classes—the monetary system and NFI. The monetary system performs the primary role of purchasing securities and creating money. NFI, in contrast, perform only the intermediary role of purchasing primary securities and creating non-monetary claims on themselves.

These claims may take the form of saving deposits, shares, equities and other obligations. NFI include various types of investment houses, construction companies, advancing loans, life insurance companies, loan associations, credit unions, postal saving system, land banks, etc. The activities of these NFIs affect the money market in the long-run (secularly) and in the short-run (cyclically). For example, in the long-run, there may be a rapid growth in the velocity of circulation of money due to NFI and the money supply may be higher than it would otherwise be in the absence of these institutions.


As such, the significance of monetary policy followed on account of the activities of banks alone, stands diminished or reduced to the extent of the activities being performed by the NFI in the money market and which are outside the control of central bank. But short-term cyclical aspect of the decline in the effectiveness of monetary policy, on account of the activities of NFI has received greater attention.

The fact is that as soon as the monetary authorities follow a tight money policy to restrict credit, it can be obtained from other financial institutions, which are not subject to the quantitative or qualitative controls by the central bank—thereby severely restricting the effectiveness of monetary policy. The existence of a large and widely distributed public debt along with a broad and efficient market for government securities lends further strength to the above argument.

There are, however, others like J. Ascheim, Shapiro, Warren Smith who feel that the effectiveness of central bank monetary policy is not weakened but actually strengthened on account of the increase of direct influence of the authorities on NFI.

In this context J. Ascheim observes, “Thus, the growth in government debt has widened the scope of direct contact between the monetary authority and the various financial institutions. It has heightened the independence between the various sectors of the money and capital markets, and has increased the substitutability between financial assets. In consequences, the direct effects of monetary policy on financial institutions of all types have been strengthened rather than weakened.”

The debate, thus, leads to the conclusion that the regulation and control of overall liquidity position of the economy is the right way to make monetary policy relatively more effective. The monetary regulations of the authorities should cover the activities of NFI also.

Monetary policy in order to be effective must cover and deal with the entire range of liquid assets. According to the Radcliffe Committee Report, “The concept of liquidity will force us to take into account not only the banking but also the non-banking institutions which are capable of creating liquid assets or which can make existing assets more liquid”.