Economics For Public Policy Notes

Economics for Public Policy

Week 1: How Economists Think

• The challenge: governments are increasingly employing professional economists to work alongside policy generalists

• You are likely to be asked to collaborate with and/or direct these professional economists

• To meet this challenge effectively, you will require a critical appreciation of the mainstream economic approach

Rational Choice Theory: Implications and Anomalies

What is Economics?

• Backhouse & Medema (2009) point to evolving views in the profession.

• Early definitions emphasised subject matter: economics was about nationalwealth and economic growth.

• Marshall (1890) instigated a shift towards individualism: economics wasprimarily a study of man.

• Robbins (1932) introduced the notion of scarcity: economics was ‘thescience which studies human behaviour as a relationship between ends andscarce means which have alternative uses’.

• From 1940’s, greater emphasis on the choice process and rational action.

• Becker (1976) emphasised approach: economics combines assumptions ofmaximising behaviour, market equilibrium, & stable preferences

• But if economics is an approach (a framework), rather than a subject matter, what should it be applied to?

• Robbins: as long as there are opportunity costs imposed by scarcity, there are no limitations on the subject matter of economic science

• Becker: the economic approach is applicable to all human behaviour, be it behaviour involving money prices or imputed shadow prices

• Which view do you agree with?

Rational Choice Theory

• Exogenous – something determined outside of the economic model

• Endogenous – something determined inside the relevant economic model

• Total cost = opportunity cost + actual cost/explicit cost + implicit cost

• Opportunity cost is of NEXT BEST ALTERNATIVE – can only do one alternative

• Transitivity allows indifference

• General equilibrium effect – where changes in one market affect another market

• Partial equilibrium – where a market is analyzed in equilibrium

Macroeconomics and Microfoundations

Simon Wren-Lewis

• An example of micro to macro: Ricardian Equivalence

• An example of macro from data: The Philips Curve

• A synthesis? The Great Moderation

• The crisis – where does this leave macro?

History of Macroeconomic Thought

Classic model: idea of representative agent, micro to macro

• Full employment and price adjustment

Keynes General Theory and Post-war Macro

• Great Depression led to separate discipline of macro

• Aggregate relationships validated by econometrics

• Microfoundations take a back seat

• How prices adjust also takes a back seat – comes unstuck with 1970s inflation (Friedman)

New Classical counter-revolution (Lucas)

• Rational expectations, Ricardian Equivalence

• Demand denial, ‘schools of thought’ macro

New Keynes consensus?

• Microfounded price stickiness, so microfound Keynesian theory

2008 crisis – what consensus?

Microfoundations example: consumption

• Would you spend a one-off tax cut (ceteris paribus – all things equal)

• How does the government ay for the cut?

  • Assume government spending (now and future) is unchanged

  • So you assume the money is borrowed

  • Borrowing implies higher future taxes at some point

• So you really should tell yourself that you’re better off in the short term, but will have higher taxes in the long term

• A rational consumer will take this into account

• Consumption smoothing by borrowing and saving. People borrow or save to get a balance of consumption over their life, even if income is unbalanced (ex. saving for retirement)

How to avoid consuming less in the future – an example

• $100 tax cut

• Government borrows the money, and pays back the borrowing after 10 years. In addition it pays 5% on that borrowing after 10 years. So taxes rise by $5 each year for 10 years, and then by $100 in the final year.

• You can invest money at a 5% interest rate. To pay the higher taxes without reducing consumption you need to invest all of the tax cut.

• So you save all of the tax cut. Saving anything less means you consume more now, but less later.

Ricardian Equivalence

• The idea that a tax cut will be completely saved by consumers

• Needs consumption smoothing – but this is just the apples and pears choice problem, except that it is consumption today or consumption tomorrow

• Key assumptions:

  • Rationality

  • You can borrow or save as much as you want, at the same rate of interest that the government pays on its borrowing

  • You will be paying taxes when the tax increases take place

• Final assumption may be empirically less important. Second could be, but it modifies theory rather than destroying it

• Key policy implications: austerity that involves temporary tax increases will have less of a demand impact than temporary cuts in government spending.

Business Cycle Analysis: The Phillips Curve

• Keynesian theory: business cycles due to movements in aggregate demand

  • Alternative New Classical Theory – Real Business Cycles – implies cycles involve voluntary unemployment

  • Keynesian theory needed a model of inflation

• Originally an empirical observation by Phillips

  • As unemployment went down, inflation increased

  • As unemployment increased, inflation decreased

  • This is the Phillips curve

• 1970s stagflation

  • There was high inflation and high unemployment

  • Excess demand ratchets up inflation

• Friedman 1968 AEA presidential address

  • Inflation depends on expected inflation as well as unemployment – a new variable

If expectations are backward-looking

• A boom, or an oil price increase, will raise inflation, but if expectations about inflation follow, ending the boom (or stabilizing oil prices) will leave you with higher inflation

• Booms (or oil price hikes) have to be followed by recessions to keep inflation constant

• 1970s story: oil prices. Initially governments failed to do this, and even tried to do the opposite (because higher oil prices tended to reduce demand), so inflation accelerated. Inflation only brought down by significant recessions.

Microfoundations and the Phillips...

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