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Economics For Public Policy Notes

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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?

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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?
o Assume government spending (now and future) is unchanged o So you assume the money is borrowed o 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: o Rationality o You can borrow or save as much as you want, at the same rate of interest that the government pays on its borrowing o 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.

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Business Cycle Analysis: The Phillips Curve
 Keynesian theory: business cycles due to movements in aggregate demand o Alternative New Classical Theory - Real Business Cycles - implies cycles involve voluntary unemployment o Keynesian theory needed a model of inflation
 Originally an empirical observation by Phillips o As unemployment went down, inflation increased o As unemployment increased, inflation decreased o This is the Phillips curve
 1970s stagflation o There was high inflation and high unemployment o Excess demand ratchets up inflation
 Friedman 1968 AEA presidential address o 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 curve
 Inflation will be forward-looking. If expectations are rational, people take account of what the government or central bank will do
 1970s: government allowed inflation drift, so expectations in inflation would rise if inflation rose
 2000s: independent central banks with inflation targets would not let inflation drift, so expectations about inflation more stable
 Great Moderation/New Keynesian synthesis
 Current recession - floor?
The 2008 crisis: the Queen's question
 Why didn't you guys see this coming?
 Financial crisis was largely unforeseen by mainstream macroeconomists, Keynesian or otherwise
 We know macroeconomics is too imprecise to produce good forecasts, but
 Independent role for banks in macro had been downplayed - as in Ricardian Equivalence
 Modelling of credit, and bank leverage, difficult from a microfoundations perspective
 So macroeconomics in general was not well-prepared, perhaps because it had overemphasized micro theory at the expense of looking at the date
 But we are rapidly catching up
 And macro policy did respond appropriately in 2009 (until the debt crisis) It is also political
 US is leader in macro, and there the subject is significantly politicized, and perhaps more ideological than in the UK
 Dislike of government intervention among large section of US academic macroeconomists
 Flash point was the use of fiscal policy to mitigate the recession in the UK and US, despite its (qualified) usefulness according to new Keynesian theory

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Will macro go back to different schools of thought, or will the New Keynesian consensus reemerge?

Rational Choice Theory
 Mainstream economic theory is based on rational choice theory.
 Individuals have rational preferences.
 It is as if individuals make choices so as to maximise (expected) utility
 Rationality means taking into account opportunity costs, but not sunk costs You should be able to answer these questions.
 What are preferences?
 What does it mean for an individual's preferences to be rational?
 What is a utility function? And do economists really think they exist?
 Why should a rational decision-maker consider opportunity costs butnot sunk costs?
 Are there limitations on the subject-matter of economic science?
Macroeconomics and Microfoundations
 Economists have studied macro subject-matter using 3 approaches. o Start with a theory of individual behaviour and aggregate up.
 This is called 'macro with microfoundations'.
 The macro models that predict Ricardian Equivalence are an example. o Start with macro data and, if a pattern emerges, model it.
 The original formulation of the Phillips curve is an example. o A synthesis of the above.
 Macro models should not be based on an assumption that individualsare persistently irrational. The expectations-augmented Phillipscurve is an example. As are some New Keynesian models. You should be able to answer these questions.
 Would a consumer (who is rational, not facing credit constraints, andyoung) save all of a temporary tax cut?
 What are the implications of Ricardian Equivalence for policy?
 What are the lessons of the financial crisis for the way economistsapproach macro subjectmatter?
Using Economic Thinking in Policy
 The case study of Uganda was intended to show how a little bit of'economic thinking' helped to solve a policy problem.
 What was the policy problem?
 In the mid 1980's, Uganda was experiencing extremely high inflation(215%).How did 'economic thinking' help?
o A macro model helped to diagnose the cause.
 Inflation was caused by increases in the money supply (M).
 These increases in the money supply were driven by the need tofinance the government budget. o The macro model also helped to suggest a solution - devalue.
 A devaluation of the official exchange rate was predicted to have afavourable impact on the budget deficit.
 The government would not print so much money.
 Inflation would decrease and the premium between official and marketexchange would fall.
 Unpopular with vested interests but economic thinking saw policy passed.

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Economics and Policy Mark Henstridge Identities
 The balance of payments must always balance o Exports less imports equals current account, which equals foreign borrowing plus change in reserves
 The central bank balance sheet must always balance
 Assets must equal liabilities
 Assets = reserves + net domestic credit. An asset is a claim on someone else
 Liabilities = money plus other items. A liability is someone else's claim on you Fiscal
 Revenue plus tax base and rate are political choices
 Grants less donors
 Spending equals political choices
 Overall balance (deficit=financing)
 Financing equals
 Foreign plus donors, or oil?
 Domestic residual
 All the considerations on the left are economic, on the right are political. Shows that economics are filtered through political considerations Financial Programming
 OB = overall balance
 FF = foreign financing
 NDA = net domestic assets
 R = revenue
 Balance of payments: o CA = Change (foreign investment) + Change (revenue)
 Central bank balance sheet: o R+NDA (net domestic assets) = M o Change R + Change NDA = Change M o Change R = Change M - Change NDA
 Fiscal accounts: o OB = FF + Change NDA o Change NDA = OB - FF
 Putting that all together: o CA=Change FI + Change R = Change M - Change NDA; and Change NDA = OB - FF Models
 Models give a framework to determine what the government should be doing with the budget
 A set of models gives a sense of economic reality Financial programming: economics in policy
 Politics: o Taxes o Spending o Foreign financing
 Institutions: o Finance ministry o Central bank o Spending ministries o Donors - and the IMF
 Collective action?
 Bargaining?

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