Economic Policy #1 The Concept of Economic Policy The Concept of Economic Policy •Approaches to economic policy •Objectives of economic policy •The whys and hows of public intervention •Evaluation of economic policy EP#1: The concept of economic policy 2 Three approaches #1 •Positive economics: –studying the effects of economy policy (EP) choices on the economy => EP is regarded as exogenous –determining transmission channels (e.g. impact of an interest rate cut) – •Normative economics: –making recommendations to the Prince –based on positive-economics results and on the Prince’s utility function –political and social constraints (second best problem) –information contraints (asymmetric information, communication failures) – EP#1: The concept of economic policy 3 Three approaches #2 •Political economics –Agents ‘ behaviour is endogenous – Government is a machine directed by rational players with specific objectives and facing specific constraints –EP is determined by policy regime EP#1: The concept of economic policy 4 The main tasks of policymakers •set and enforce the rules of the economic game •tax and spend •issue and manage the currency •produce goods and services •fix problems (or pretend to) •negotiate with other countries EP#1: The concept of economic policy 5 A general framework of EP making EP#1: The concept of economic policy 6 Role of institutions •Douglass North (1993): “Institutions are the humanly devised constraints that structure human interaction. They are made up of formal constraints (rules, laws, constitutions), informal constraints (norms of behavior, conventions, and self imposed codes of conduct), and their enforcement characteristics.” • •Institutional framework affects directly market equilibriums and effectiveness of EP instruments. EP#1: The concept of economic policy 7 Objectives of EP (examples) •Humphrey-Hawkins Act (USA): –“promote full employment and production, increased real income, balanced growth, a balanced Federal budget, adequate productivity growth, proper attention to national priorities, achievement of an improved trade balance..” •Article 3 of the treaty on the EU: –“work for the sustainable development of Europe based on balanced economic growth and price stability, a highly competitive social market economy, aiming at full employment and social progress, and a high level of protection and improvement the quality of the environment.” •=> Objectives of EP are numerous and sometimes contradictory. EP#1: The concept of economic policy 8 EP as a succession of trade-offs •Tinbergen rule: to reach an indepedent –objectives governents needs at least –an equal number of EP instruments. • • • •In reality, number of instruments < number of objectives • => there are inevitable trade-offs EP#1: The concept of economic policy 9 Economic management vs. structural reform #1 EP#1: The concept of economic policy 10 Economic management vs. structural reform #2 •Economic management contains various levers such as tax rates, interest rates and public spending. • •Structural reforms aim to modify EP trade-offs by changing the institutions (CB independence, choosing a currency regime, adopting framework for budgetary policy etc.) EP#1: The concept of economic policy 11 The employment-productivity trade-off EP#1: The concept of economic policy 12 Structural reforms in post-communist countries Structural reforms often have negative short-term, but positive long-term effects. EP#1: The concept of economic policy 13 The Whys and Hows of Public Intervention •Three functions of economic policy (Musgrave&Musgrave, 1989): •Allocation ó market inefficiency (ex. competition, education, climate) •Macroeconomic stabilization ó nominal rigidities (ex. monetary and fiscal policies) •Income redistribution ó corrects the primary distribution of income (eg. taxation, social transfers, housing) EP#1: The concept of economic policy 14 Stabilization vs. allocation policies •=> Allocation policies impact potential output •=> Stabilization policies impact the output gap EP#1: The concept of economic policy 15 Collateral efffects EP#1: The concept of economic policy 16 More on allocation •Imperfect competition: fight market power, regulate innovation rents and natural monopolies –Instruments: antitrust, intellectual property, regulation etc. •Externalities –Instruments: regulation, taxes or markets (Coase theorem) •Imperfect information: innovation rents, consumer illiteracy, moral hazard, conflicts of interest –Instruments: mandatory disclosure, financial regulation, etc. •Incomplete markets –Instruments: public education, credit enhancement EP#1: The concept of economic policy 17 More on stabilization #1 •J. M. Keynes (1883-1946): •private instability (‘animal spirit‘) + ineffective self-correcting mechanisms (nominal rigidities) • •=> need for counter-cyclical policies to smooth out economic fluctuations and prevent economic depressions. EP#1: The concept of economic policy 18 More on stabilization #2 EP#1: The concept of economic policy 19 More on redistribution #1 •Two arguments: –Pareto optimality (resulting from first welfare theorem) does not amount to social justice –Efficiency-enhancing policies (e.g. trade) make winners and losers •Income distribution can be corrected in a non-distortionary way through lump-sum transfers EP#1: The concept of economic policy 20 More on redistribution #2 •Difficult to implement in practice => frequent equity-efficiency trade-offs •Need for social-welfare criteria: –To compare gains and losses / Pareto optimum –To help address trade-offs –To act consistently • EP#1: The concept of economic policy 21 Evaluating EP: decision criteria •Single criterion for efficiency, stabilization and equity is conceivable in theory. • •In practice EP choices are generally represented as implying trade-offs between different dimensions. EP#1: The concept of economic policy 22 Ex-post policy evaluation •Controlled experiments –Individuals subject to a policy shock are compared with a pilot group •Natural experiments –Econometric technique developed to address heterogeneity and selection bias (difference in differences method) EP#1: The concept of economic policy 23 GDP as a proxy of welfare #1 •widely used in practice •misleading because overlooks leisure, depletion of natural resources, externalities •need to promote alternative measures EP#1: The concept of economic policy 24 GDP as a proxy of welfare #2 EP#1: The concept of economic policy 25