Appunti Economic policy

Overview of Economics

Economics studies the organization of exchange and production of goods from the point of view of society. The most important objective of economics is to understand if and then how the organization of exchange and production can be improved upon. This is the problem we study in Economic Policy. Throughout this book, the point of departure is a market economy, wherein for many goods and services demand and supply are matched (and thereby determined) by means of prices.

Market Economy and Government Intervention

The procedure we shall follow is as follows: we first ask if a given market functions well without government intervention. If the answer is yes, there is arguably no reason to further consider possible interventions; however, if the answer is negative, the next step is to ask if any policy may improve on the situation.

Economic Objectives for Society

The economic objectives for society are the following:

• Efficiency: One should attempt to avoid wasting resources.
• Equality: Attempting to avoid too much inequality in the distribution of income, wealth, or consumption opportunities.
• Liberty: Letting individuals have more economic choices rather than fewer.

Economists propose some intermediate objectives which are expected to contribute to reaching the fundamental ones. Among these one finds:

• Well-functioning markets
• Sustainable economic growth
• Economic stability
• A low level of unemployment
• A high income
• An income distribution that is not unequal
• A healthy natural environment
• Adequate provisions of health services
• Adequate opportunities for education
• Protection against negative economic events

Lines of Economic Research

Economists often distinguish between three lines of research:

• Positive economics: Studies the functioning of the economy from a (supposedly) objective point of view and seeks to understand how changes brought onto the economic system, whether truly (like an earthquake) or conceptually exogenous (like a war or an oil shock) will affect this system (for example, in terms of efficiency, prices, unemployment, etc.)
• Normative economics: Economists seek to formulate principles that should be achieved by the economy and to understand the interplay between these principles.
• Political economy: It is about studying the political decision process. The key idea is to establish an accordance between the objectives of society and the actual decisions taken by politicians.

Economic Systems, Institutions, and Policies

Conceptually, it is helpful to think about economic policy by making a distinction between economic systems, economic institutions, and economic policies in a narrow sense:

• An economic system: Consists of a set of economic and political institutions often with an ideological justification. Examples include a communist economic system (a planning economy), fascist economic systems (often also with a degree of planning), and a democratic market economy, also sometimes called a capitalistic system. A very fundamental right that underlies a market economy is the right to own property.
• An economic institution: Develops in the context of and possibly concurrently with an economic system. Economic institutions are often regulated or encoded into laws, such as those that grant workers the right to organize themselves into a union or the laws that establish the existence of a central bank with certain rights and obligations.
• Economic policies: Operate within the constraints set by economic institutions.

Functioning of a Market Economy

By a market economy, we mean an economic system where the government is divided into three distinct roles: legislative, executive, and judicial. Here is a brief description of how a typical market economy functions:

• It is based on a democratic constitution.
• It has legally defined private property rights.
• It has institutions that guarantee the legality of contracts and executive institutions that enforce the laws if necessary.
• It has markets for the exchange of goods, to some extent regulated by the government. Prices on these markets are defined by demand and supply but may be subject to government intervention.
• The state imposes taxes, offers transfers and provides some of the goods demanded by consumers.

GDP and GNP

The GDP (Gross Domestic Product) of a country measures the value of all products produced within the border of the country in a year minus the value of all intermediate inputs. The GNP (Gross National Product) measures the payments to all the productive factors of the country within a year. When the economy of the country is closed, there is no distinction between GDP and GNP. Divided by the number of inhabitants, they become "per capita," and as such measure the average economic (material) well-being of individuals in the country.

We know that GDP: Y = C + I + G + (X - Im) and that Savings: S = Y – C – G, which gives us: S = I + (X - Im). For citizens, we have Private Savings: Sp = Y – T – C (disposable income less consumption), and for the government, we have Government Savings: Sg = T – G (taxes less government spending). Hence: S = Sp + Sg = Y – T – C + T - G = Y – C – G = I + (X - Im). Or, if we write Bg as -Sg, Sp = I + (X - Im) + Bg (private savings can be placed either in domestic private investments, lending abroad, or lending to the government). If the private savings aren’t enough to finance investments and government borrowings, the country will borrow from abroad, hence will be in debt.

Real GDP Calculation Methods

Real GDP can be calculated in two ways:

• The Laspeyres Quantity Index, that takes the "initial year" as base year: (pI * qF) / (pI * qI)
• The Paasche Quantity Index, that takes the "final year" as base year: (pF * qF) / (pF * qI)

The two indices give different but similar results. There are several other problems with regards to GDP (per capita) if one intends to use it as a measure of economic welfare. For one, it only measures economic activity relating to the market or the government, while other activities, such as goods and services produced within the household or by volunteers who provide these for free, are not considered. Another problem: suppose an earthquake destroys a town and that it is consequently being rebuilt. This may lead to an increase in GDP but, one could argue, does not indicate an increase in overall economic well-being in the country.

Exchange Rates and Purchasing Power Parity

Data on GDP per capita when used for comparison between different countries can be misleading. To avoid this problem, GDP per capita is often measured adjusting for the Purchasing Power of the local currency. The idea is that one should compare how much on average a resident can buy for his/her income.

Consider the so-called Big Mac Index (published yearly by The Economist), that reports the local price, converted into US dollars, of a Big Mac burger in various countries. If that price is lower than the price of a Big Mac burger in the USA, we say that the local currency is undervalued (relatively to the US $), in the other case, the local currency is overvalued.

The Real Exchange Rate is equal to: (local price * nominal exchange rate) / foreign price The Purchasing Power Parity: foreign price / local price

Human Development Index

As the GDP doesn’t provide the complete picture of the well-being of a country, we can use the Human Development Index, that is based on the computation of:

• Life expectancy at birth
• Literacy level
• GDP per capita (in PPP)

Public Debt

Another important variable is the Public Deficit, D, calculated as D = iB + Gp – T where i is the interest rate paid on the government’s debt B, Gp is current government expenditure on goods and services, and T are the taxes received. If D > 0, the debt increases. Gp – T is called “primary deficit”. When either the government’s deficit or debt becomes too high, it may have difficulties financing it. This is what happened to several European countries during the crisis that started in 2008.

Employment and Unemployment

The employment rate for a country is defined as: (number of employed / number of inhabitants between 15 and 64) * 100. This rate depends, among other things, on the number of inhabitants between the age 15 and 64, the age where most people work, participation of women in the labor market and the rate of unemployment. One would expect that the higher is the employment rate, the higher is GDP (also per capita).

The unemployment rate is defined as: (number of people looking for work / number of people in the labour force) * 100, where the number of people in the labour force is equal to the number of people looking for a job plus the number of employed people. A high rate of unemployment indicates an inefficiency for the economy. A particular problem is youth unemployment where we are looking at people between the age of 15 and 24.

Aging

The fertility rate is defined as the average number of children born by women between the age 15 and 49. To have a stable population, a country needs the fertility rate to be around 2.1. A low fertility rate causes the aging index to rise. The aging index is defined as: (number of inhabitants over 65 / number of inhabitants under 15)

Inflation

By inflation we mean a general increase in the prices of goods and services, that is an increase in the price level (of a country or region). Deflation, in contrast, means a decrease in the price level. To measure it, we have two ways:

• The Laspeyres Price Index, that uses the “initial” year as base year: (fP * iQ) / (iP * iQ)
• The Paasche Price Index, that uses the “final” year as base year: (fP * fQ) / (iP * fQ)

To measure the inflation rate, we insert either the LPI or the PPI in the following formula: (LPI – 1) * 100 or (PPI – 1) * 100. Many consider a high rate of inflation a problem. First of all, we should think of inflation as a tax on holding money, that is worth less in real terms. Also, a high level of inflation means that prices are changing frequently, and this is costly: economists call this type of costs “menu costs”. Deflation can be a problem, because it could come from low demand, and could have consequences on unemployment, growth and cost of borrowing.

Balance of Payments

The balance of payments is another macroeconomic variable that economists pay much attention to. It is made of:

• Current account: Where the country records exports and imports of goods and services and primary income and current transfers.
• Capital account: Where the country records transfers and acquisition or disposal of non-produced non-financial assets (e.g., natural resources, patents, etc.), and debt forgiveness.
• Financial account: Where all acquisitions and sales of financial assets are recorded.

Every entry will be made twice (It’s a double entry system), so that the balance of CA+KA+FA is equal to 0. If a country has a large negative Current Account balance, this might indicate a problem since it means that it needs to borrow large sums abroad. In a country with a fixed exchange rate against another currency, a large Current Account deficit may lead to a depletion of the central bank’s foreign currency holdings which are needed to keep the exchange rate constant. Thus, a large Current Account deficit may lead to a loss of confidence in the ability of the central bank to keep the exchange rate constant and then to a currency crisis with a devaluation as a possible outcome. This is one reason why economists pay attention to the Current Account of countries with fixed exchange rates.

Inequality

Differences in wealth and income should be taken into account when assessing the economic performance of a given country. One way to look at inequality (whether income or wealth) is by means of the Lorenz curve, which presents the relationship between the percentage of individuals (or households) with the lowest incomes (or wealth) and the percentage of total income these people earn (or the percentage of total wealth they have). The figure says that, if you rank households according to their incomes, the bottom 25% earns 10% of all income in this society. If you consider the bottom 50%, they earn 25% of all incomes. You have zero inequality only if the Lorenz curve is a straight line, going from (0,0) to (100,100).

If we compare two countries, we can only define if a country is better than the other if the Lorenz curves don’t overlap. To have more precise data we can use the Gini coefficient, that is the ratio between the area A and the area A+B. Given that A+B= ½, we get that the Gini coefficient G= 2A. G=0 corresponds to the case of perfectly equal distribution. G=1 corresponds to the case of perfectly unequal distribution. Disposable income takes into account the redistribution resulting from higher taxes on high income earners (and possible transfers paid to low income earners). Usually, a redistribution of incomes via the tax system leads to lower inequality. A high inequality causes the decrease of the demand of goods on the market (because people can’t afford them). Inequality can be measured in terms of wealth, income, consumption possibilities.

To find out which one is the most adequate, we consider the life cycle income model: This model illustrates a typical profile for income, wealth and consumption over the lifetime of an individual. Initially, this individual has a low or no income and thus needs to borrow money to sustain a certain level of consumption. As the individual gets older, his income increases and hits a maximum shortly before or at retirement. At the point of retirement, the individual has no income from working, but only from the returns on his savings. This shows that the Lorenz curve isn’t always accurate, because people could have or not have an income, depending on their age, which would show an inequality. For example, elderly people have no income, hence they would result as not having income, but they could live off huge savings. Consumption inequality is probably the most adequate measure.

Efficiency and the Role of Models

Adam Smith proposed that in a market economy, efficiency is reached by means of an “invisible hand”: even though everyone is only doing what is best for his own interests, in the end society reaches a state where there is no waste of resources. If this is really so, there is no need for the government’s hands to be involved. However, efficiency is not guaranteed. Economists tend to modify the position of Smith by suggesting that government intervention should only be used if efficiency or other objectives of society are not realized. Free markets are the default option, and government interventions are justified only when they can improve the social outcome.

First, we investigate if the market, when left alone, accomplishes the goals set by society. If not, we ask if government intervention could improve on the situation. There are three types of intervention which are particularly important:

• To improve on efficiency
• To stabilize the macroeconomy
• To reallocate incomes and consumption in order to reduce inequality

Pareto Efficiency

Let's define two concepts:

• Pareto improvement: A change in the allocation of resources for consumption that makes someone strictly better and no one worse off.
• Pareto inefficiency: A condition that allows a Pareto improvement
• Pareto efficiency: A condition that doesn’t allow a Pareto improvement, which means it isn’t possible to make one agent better off without making the other worse off.

If the consumption allocation isn’t Pareto efficient, there’s a waste of resource. Adam Smith said that an individual, by pursuing his own interest, promotes the efficiency of society. The Prisoner’s Dilemma, however, illustrates a problem with such an idea.

Prisoner's Dilemma

There are two criminals, A and B, held in separate cells. Each of them has the choice between confessing to a crime they did together or keeping silent. By a Nash equilibrium we mean a strategy assigned to each agent, such that for any agent, his assigned strategy is optimal given the strategy assigned to the other agent. In the Prisoner’s Dilemma game, there is only one Nash equilibrium namely where both prisoners confess. However, this Nash equilibrium is from the point of view of the “society” consisting of the two prisoners, inefficient. If they both choose N, they would both be better off, i.e. they would realize a Pareto improvement.