Lecture 3 Normative Theory

Lecture 3
Normative
theory of
economic policy
Economic Policy Analysis
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
• The fixed target approach

• The priority approach
• The flexible target approach with a variable
MRS
• The flexible target approach with a constant
MRS
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
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.
• 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 only.
• The number of reduced form equations = the number of targets
The reduced form model
• With two targets y1 and y2 and two instruments x1 and
x2, the reduced form model is
• The inverse reduced form

• Expressing the instruments as a function of the targets
• Final
step
• Assigning a value to the targets
• ‘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
• 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
]
• Subject to
• 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’ behaviour.
• 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.

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Lecture 3

• The fixed target approach

• Assigning fixed values to the variables chosen as

• The approach involves maximising the value of the

• A reduced form of the model

• The inverse reduced form

• ‘Golden rule’ of economic policy

• Number of targets larger than the number

• This problem can be solved even if the number of instruments is

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