You are on page 1of 18

Lecture 3

theory of
economic policy
Economic Policy Analysis
Dr Dragana Radicic
Normative and positive theories
of economic policy
• The normative theory focuses on the abstract potential for
action by a government, acting rationally, in a market
economy should do to compensate for market inadequacies.
• The positive theory examines the actual behaviour of
government, comparing it with the abstract structure
derived in the normative theory.
• The formulation of both a normative and a positive theory
of public involvement in the economy are necessary if we
wish to reach some sort of conclusion regarding the relative
roles to assign to government and the market in ‘regulating’
the economic activity of individuals.
Planning- meaning and
• Planning means taking coordinated and consistent economic
policy decisions.
• Why is coordinated action needed?
• A variety of instruments are available to achieve the
various possible objectives.
• The existence of multiple objectives and the fact that
each instrument can influence more than one objective
means that policy problems are interdependent.
• Policy problems are intertemporal.
• A plan (or programme) is formed of three elements: targets,
instruments, and an analytical model.
Approaches in expressing
policy objectives

• The fixed target approach

• The priority approach
• The flexible target approach with a variable
• The flexible target approach with a constant
Fixed targets

• Assigning fixed values to the variables chosen as

economic policy targets.
• Example:
• Derived Phillips curve
The priority approach

• The approach involves maximising the value of the

non-priority target, subject to the desired value of
the priority target and the constraint of the model
that represents functioning of the economy.
• Example:
• Employment and price stability
Flexible targets: SWF with variable MRS
• The economic problem solution can be found by comparing the social
indifference map with the transformation curve (utility possibility frontier).

• Unlike the fixed approach, the targets are determined endogenously as the
values that maximise social welfare, given the constraint (i.e. optimising
Flexible targets: SWF with increasing MRS
• SWF should be minimised (e.g. inflation, unemployment
Flexible targets: SWF with constant MRS
Instruments of economic policy
• A variable can be defined as a policy instrument if the
following three conditions are satisfied:
• Policymakers can control the variable
• The variable whose value has been fixed by
policymakers has an influence on other variables,
which are assigned the role of targets (effectiveness)
• It must be possible to distinguish the variable from
other instruments in terms of its degree of
controllability and effectiveness (separability or
Different types of instrument
• Quantitative policies
• Changing the value of an existing instrument
• Qualitative policies
• Introduction of a new instrument or the elimination of an existing
• Reform policies
• Introduction of a new instrument or the elimination of an existing
one that causes the significant change in the economic system
• Direct and indirect control measures
• Direct = aim to achieve certain objectives by imposing a given
behaviour on certain categories of agents
• Indirect= fiscal policy, monetary policy and exchange rate policy
Discretionary measures and
automatic rules
• Discretionary measures
• Policy instruments that can be adjusted at
the policymaker’s discretion in a case-by-
case assessment
• Automatic rules
• Monetary or fiscal constitution
• Automatic (or built-in) stabilisers
A policy or decision model
• The structural form of the model
• Endogenous variables are expressed as a function of other
endogenous variables as well as exogenous variables.

𝑦 = 𝑓(𝑦, 𝑥)

• A reduced form of the model

• Obtained from the structural model by eliminating through
substitution all the irrelevant variables and expressing each
residual endogenous variable in terms of exogenous variables
• The number of reduced form equations = the number of
The reduced form model
• With two targets y1 and y2 and two instruments x1 and
x2, the reduced form model is
𝑦1 = 𝑓1 (𝑥1 , 𝑥2 )

𝑦2 = 𝑓2 (𝑥1 , 𝑥2 )

• The inverse reduced form

• Expressing the instruments as a function of the targets

𝑥1 = 𝜙1 (𝑦1 , 𝑦2 )
𝑥2 = 𝜙2 (𝑦1 , 𝑦2 )
The reduced form model
• Final step
• Assigning a value to the targets

𝑥1 = 𝜙1 (𝑦ത1 , 𝑦ത2 )

𝑥2 = 𝜙2 (𝑦ത1 , 𝑦ത2 )
• ‘Golden rule’ of economic policy
• In the case of fixed objectives, the solution of an
economic policy problem requires that the number of
instruments be at least equal to the number of targets.
• Determined and underdetermined
(overdetermined) systems
The reduced form model

• Number of targets larger than the number

of instruments
• Drop the excess targets
• Find new instruments
• Abandon the attempt to set the policy
problem in terms of fixed targets in favour
of a flexible target approach
Flexible targets
• A flexible objective problem is framed in terms of
maximising or minimising a social welfare function subject
to the constraints given by the relationships of the model,
which represent functioning of the economic system.
• We two generic targets y1 and y2, we have

𝑚𝑎𝑥[𝑊 = 𝑓(𝑦1 , 𝑦2 )]
• Subject to
𝑦1 = 𝑓1 (𝑥1 , 𝑥2 )
𝑦2 = 𝑓2 (𝑥1 , 𝑥2 )

• This problem can be solved even if the number of

instruments is less than the number of targets.
Lucas critique
• Decisions models ignore the feedback effect of government
decisions on the behavioural functions of private agents.
• Changes in policy regimes can influence the parameters of private
behavioural functions or the functional form of private agents’
• Forecasting based on the past data might not take into account
changes in the parameters or the functional form.
• Practical problem
• The amount by which parameters change in response to the change in
economic policies is important.
• Theoretical contribution
• The Lucas critique underscores the presence of reciprocal interactions
between the behaviour of private agents and government.
• The private sector plays an active rather than passive role.