Professional Documents
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Normative
theory of
economic policy
Economic Policy Analysis
Dr Dragana Radicic
dradicic@lincoln.ac.uk
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
foundation
• 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
• Unlike the fixed approach, the targets are determined endogenously as the
values that maximise social welfare, given the constraint (i.e. optimising
approach).
Flexible targets: SWF with increasing MRS
• SWF should be minimised (e.g. inflation, unemployment
etc.)
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
(controllability)
• 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
independence)
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
one
• 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)
𝑦2 = 𝑓2 (𝑥1 , 𝑥2 )
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
𝑚𝑎𝑥[𝑊 = 𝑓(𝑦1 , 𝑦2 )]
• Subject to
𝑦1 = 𝑓1 (𝑥1 , 𝑥2 )
𝑦2 = 𝑓2 (𝑥1 , 𝑥2 )