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Full summary Economic Policy
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Summary of the course Economic Policy , given by Johan van Gompel at the University of Antwerp. Powerpoints are combined with own lecture notes.
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Economic policyInhoudsopgave
Chapter 1: An introduc2on .............................................................................................................................. 1
1. A primer on economic policy: the hows and the whys .................................................................................... 1
1.1. The general framework............................................................................................................................ 2
1.2. The three key func6ons of economic policy ............................................................................................ 3
1.3. Discre6on versus rules ............................................................................................................................. 5
2. Evalua:on and limits of economic policy making ........................................................................................... 6
2.1. The limits of economic policy .................................................................................................................. 7
2.2. The limits of benevolence........................................................................................................................ 7
3. GDP: king of economic measurement, but only a (bad) proxy of human well-being ...................................... 8
3.1. Economic policy in prac6cal terms .......................................................................................................... 8
4. Economic policy in a VUCA world, full of shocks/chaos, regime changes and trends ..................................... 9
4.1. Technocrats at the helm .......................................................................................................................... 9
4.2. A constantly changing environment: shocks/chaos, regime changes and trends ................................. 10
4.3. Is it possible to be prepared for a crisis? ............................................................................................... 11
Chapter 2: Fiscal Policy .................................................................................................................................. 13
1. Public finances and fiscal policy .................................................................................................................... 13
1.1. An introduc6on ...................................................................................................................................... 13
1.2. Theory behind fiscal policy .................................................................................................................... 14
1.3. The fiscal policy stance .......................................................................................................................... 14
2. The effec:veness of fiscal policy: does it really work? .................................................................................. 16
2.1. The effec6veness of automa6c stabilisers ............................................................................................. 16
2.2. The effec6veness of discre6onary policy ............................................................................................... 17
2.3. Austerity versus s6mulus ....................................................................................................................... 19
3. Public debt .................................................................................................................................................... 20
3.1. The burden of public debt ..................................................................................................................... 21
3.2. The mechanism of debt dynamics ......................................................................................................... 23
3.3. A dangerous doom loop ........................................................................................................................ 25
3.4. Public debt sustainability ....................................................................................................................... 25
3.5. Implicit public debt = 'hidden debt' ....................................................................................................... 26
4. The EU framework for fiscal surveillance and fiscal rules aUer Covid-19. ..................................................... 27
4.1. The EU mechanism for fiscal surveillance.............................................................................................. 27
4.2. Fiscal policy in Covid and war 6mes ...................................................................................................... 28
4.3. Fiscal rules post-pandemic/energy crisis ............................................................................................... 29
5. Next Genera:on EU, the need for a fiscal union ........................................................................................... 30
Chapter 3: Monetary policy - Exit from monetary s2mulus ............................................................................ 31
1. What do central banks do? What are the key objec:ves? ............................................................................ 31
1.1. The emergence of price stability as a policy goal .................................................................................. 32
1.2. The Fed versus the ECB .......................................................................................................................... 34
2. The toolkit (instruments) and transmission mechanism of monetary policy. ................................................ 36
2.1. The general framework of monetary policy .......................................................................................... 36
2.2. Instruments of (conven6onal) monetary policy .................................................................................... 36
2.3. Opera6ng and intermediate targets of monetary policy ....................................................................... 37
2.4. Transmission mechanism of monetary policy........................................................................................ 38
2.5. monetary policy and the exchange rate regime .................................................................................... 38
3. Whatever it takes: unconven:onal monetary policy in crisis :mes............................................................... 39
3.1. The ECB’s unconven6onal (non-standard) policy measures .................................................................. 39
3.2. Forward guidance on the stance of monetary policy ............................................................................ 41
3.3. Financial stability func6on in crisis 6mes .............................................................................................. 42
3.4. Evalua6ng past loose monetary policy .................................................................................................. 42
3.5. Evalua6ng past loose monetary policy .................................................................................................. 42
4. Where from here? The new Fed and ECB policy strategy. The exit from monetary s:mulus. ....................... 43
1
, 4.1. Monetary policy strategy on the move.................................................................................................. 43
4.2. Quan6ta6ve Tightening (QT) ................................................................................................................. 44
4.3. Policy rates: end of 6ghtening cycle ...................................................................................................... 45
5. Paradigm shiUs: Modern Monetary Theory, Green Monetary Policy, Central Bank Digital Currencies. ........ 45
5.1. Modern Monetary Theory (MMT) ......................................................................................................... 45
5.2. Green monetary policy .......................................................................................................................... 47
5.3. Central bank digital currencies .............................................................................................................. 48
Chapter 4: Labour market policy ................................................................................................................... 51
1. Some concepts and defini:ons & the costs of being unemployed ................................................................ 51
1.1. Concepts and defini6ons ....................................................................................................................... 51
1.2. The unemployment rate ........................................................................................................................ 53
1.3. A broader view ...................................................................................................................................... 54
1.4. The costs of being unemployed ............................................................................................................. 55
2. Theories on the existence of unemployment: various causes and forms ...................................................... 56
2.1. Unemployment can have various causes and take various forms ......................................................... 56
2.2. Classical versus cyclical unemployment................................................................................................. 57
2.3. Classical versus cyclical unemployment................................................................................................. 57
2.4. Structural unemployment ..................................................................................................................... 58
2.5. Long-term unemployment..................................................................................................................... 58
2.6. Fric6onal unemployment ...................................................................................................................... 59
2.7. Natural unemployment and NAIRU ....................................................................................................... 59
2.8. Hysteresis in unemployment ................................................................................................................. 59
3. Ac:ve labour market policies: do they work? ............................................................................................... 60
3.1. Ac6ve labour market policies ................................................................................................................ 61
3.2. The Beveridge curve .............................................................................................................................. 62
3.3. Shid from passive income support to ac6ve measures? ....................................................................... 63
4. The role of labour market ins:tu:ons: are they employment-unfriendly?.................................................... 63
4.1. Ins6tu6onal and structural features ...................................................................................................... 63
4.2. How (un)employment performance might be affected: some examples .............................................. 64
4.3. There is no single model that guarantees successful labour market performance ............................... 65
5. Labour market faces many challenges: the need for structural reforms. ...................................................... 66
5.1. Challenges for labour markets now and in the future ........................................................................... 66
5.2. Embracing technology as an opportunity .............................................................................................. 67
5.3. How the future labour market will look like .......................................................................................... 68
5.4. The need for structural reforms: More ‘flexicure’ labour markets ........................................................ 68
5.5. Policy recommenda6ons in the OECD Jobs Strategy ............................................................................. 69
Chapter 5: Supply-side policy - The economy’s longer-term poten2al ............................................................ 71
1. What it is about: policies designed to improve the economy’s produc:ve capacity. .................................... 71
2. The benefits of growth: why does economic growth maber? ....................................................................... 71
3. How supply-side policies work: advantages, types and limita:ons. ............................................................. 73
3.1. The economic advantages ..................................................................................................................... 73
3.2. Two types of supply side policies........................................................................................................... 73
3.3. Limita6ons of supply-side policies ......................................................................................................... 74
4. Technological innova:on, a major force in economic growth. ...................................................................... 75
4.1. Produc6vity slump ................................................................................................................................. 76
4.2. Is the slump here to stay? ...................................................................................................................... 76
5. The impact of the pandemic and ongoing trends ......................................................................................... 77
5.1. Implica6ons of popula6on ageing ......................................................................................................... 77
5.2. Implica6ons of climate change .............................................................................................................. 79
,Chapter 1: An introduc2on
1. A primer on economic policy: the hows and the whys
Today’s introduc0on sets out the general framework of economic policy-making (i.e. some
methodological founda0ons and toolbox essen0als):
• Alterna0ve approaches
• Objec0ves and instruments
• Keyfunc0ons
Different economic policies covered in the course:
• From a macroeconomic point of view
• By no means comprehensive (only the main types of economic policy)
• Approach is prac0cal and strongly relies on facts (as ‘reading assistance’ each policy topic
covered in the course includes charts and data)
What do policymakers do in prac0ce?
1. Set and enforce the rules of the economic game
o Economic legisla0on provides the framework for the decisions of private agents
2. Collect taxes and spend
o Public spending oRen amounts to close to one-half of GDP in developed countries
3. Produce public goods and services
o Providing educa0on, healthcare, public transport,...
4. Issue and manage the currency
o Choice of a monetary and exchange-rate system
5. Fix all kind of economic problems
o Ministers are held responsible for a vast array of economic issues
6. Nego0ate economic ma\ers with other countries
o On ma\ers like trade liberalisa0on, sustainable development goals,...
Main types of economic policy
• Fiscal policy: Changes in government spending or taxa0on to influence macroeconomic
condi0ons
• Monetary policy: Changes in the money supply or interest rates usually to influence the rate
of infla0on
• Labor market policy: Interven0ons in the labor market to protect workers in adverse
circumstances and to help the unemployed find work
• Supply-side policy: A\empts to increase the produc0ve capacity of the economy
1
,Three alterna*ve approaches
An economist can adopt diverse a_tudes vis-à-vis policy decisions
1. Posi0ve Economics: Limi0ng oneself to studying the effects of policy decisions on the
economy
o Outside observer’s viewpoint, policy decisions regarded as exogeneous
o Example: “What is the effect of a rise in the policy interest rate on infla0on?
2. Norma0ve Economics: Seeking to influence policy decisions trough recommenda0ons based
on one’s exper0se
o Economist adopts the posture of a policy advisor (how to design and implement
policies)
o Implies norma0ve assessment (explicit or implicit assump0ons about social
preferences)
o Example: “What monetary policy to prop up recovery while maintaining long-term
price stability?”
3. Poli0cal Economics: Taking policy decisions as a topic for research and study their
determinants
o Takes the viewpoint of an external observer and considers the policymakers’
behaviour as endogenous
o The policymakers are regarded a machine directed by poli0cians
o Example: “Should the central bank’s mandate give more emphasis on financial
stability?”
1.1. The general framework
Dis0nguish between:
• Policy objec0ves (e.g. full employment, price stability) which are numerous and some0mes
contradictory
o Are not always going to be reached
• Policy instruments (e.g. fiscal policy, monetary policy, trade policy)
• Ins0tu0ons (e.g. independent central bank, wage-se_ng procedures, trade unions) and the
(uncertain) environment (e.g. demographics, policies conducted by other countries)
=> Policymakers use instruments to reach objec0ves put forward, knowing that the rela0onship
between the two depends on ins0tu0ons and the environment
Two approaches in looking at economic policy:
• Standard approach takes ins0tu0ons and the environment as given
• Structural reforms at changing the ins0tu0ons (ins0tu0ons are not eternal)
• If you have 1 objec0ve and 1 instrument -> the objec0ve is going to be reached
• If you have too many objec0ves, you can’t reach them all
2
,Trade-offs are part of a government’s everyday life
• These trade-offs are condi0onal on its preferences
o E.g. how much more wage inequality the government stands ready to accept to
reduce the unemployment rate by one percentage point.
o You can reduce the minimum wage to lower unemployment, but this will increase
inequality
• The original Phillips curve
o Inverse rela0onship (trade-off) between infla0on and unemployment.
• Employment growth versus produc0vity growth
o In some European countries fewer people work, but those who work have a high
level of produc0vity. Other countries achieve much be\er performances about
employment but at the price of weaker produc0vity.
o Answer to this trade-off: reshaping ins0tu0ons (requiring supply side policies), like
e.g. more investment in educa0on and lifelong learning, an environment that fosters
innova0on,...
Policy trade-offs versus structural reforms
• Tradeoffs will play to a lesser extend
• The problem can be solved by changing
ins0tu0ons
1.2. The three key func6ons of economic policy
Towards an economy that is efficient, stable and fair (Musgrave, 1989)
1. Alloca0on func0on:
o Dividing total resource use between private and social/public goods and choosing the
mix of social/public goods
o Improving efficiency in the economic system
o E.g. infrastructure, educa0on, compe00on
2. Stabilisa0on func0on:
o Elimina0ng short-term rigidi0es and business cycle fluctua0ons
o Achieving the main macroeconomic objec0ves set by policymakers to ensure stable
economic growth, price stability, and sustainable external accounts
o E.g. expansionary/restric0ve monetary and fiscal policies
3. Distribu0on func0on:
o Ensuring fairness by adjus0ng the primary distribu0on of income or wealth
o E.g. taxa0on, social transfers, housing policy, regional policy
More on alloca*on – Why should the government intervene?
JusFficaFon for intervenFon based on microeconomic arguments (market failures:)
Compe00on is not perfect:
• Some firms enjoy to much market power (cf. monopolies)
• Policy response: compe00on policy, an0trust laws, regula0on (e.g. intellectual property),...
Economic ac0vi0es have external effects:
• Climate change, systemic risk from banking ac0vi0es,...
• Policy response: internalise them through taxa0on (e.g. of carbon), financial regula0on,..
Informa0on is imperfect:
3
, • Consumer illiteracy (analfabe0sme), moral hazard, conflict of interest,...
• Policy response: mandatory closure, accoun0ng standards,...
Markets are incomplete:
• Some necessary condi0ons for market forma0on exist but not all of them, so firms entering
the market will only sa0sfy a limited propor0on of poten0al demand
• Policy response: public educa0on, credit enhancement,...
More on stabilisa*on – Why should the government intervene?
Reducing volaFlity in the economy and encouraging welfare-enhancing growth
Smoothing short-term fluctua0ons:
• Limi0ng erra0c swings in total output (business cycle) as well as controlling surges in infla0on
or defla0on, generally leading to healthy levels of employment and sustainable external
accounts
• Policy response: two types of counter-cyclical policies, i.e. discre0onary measures (e.g.
changes in policy interest rates, increase in public investments) and automa0c stabilizers (e.g.
system of unemployment benefits, automa0sche loonindexering)
Preven0ng economic and financial instability:
• Answer to demand and supply shocks (e.g. financial crisis & pandemic crisis)
• Irra0onal exuberance on financial markets may lead to boom-bust cycles
• Policy response: targeted and temporary discre0onary measures, oRen requiring dras0c
s0mulus in a coordinated manner among different government levels
• E.g. Draghi: ‘ECB will do whatever it takes to save the euro’
Alloca*on versus stabilisa*on
• Alloca0on policies impact poten0al output
(maximum amount of goods and services an
economy an turn out when it is most efficient)
• Stabiliza0on policies impact the output gap
(difference between the actual output of an
economy and its poten0al output)
More on redistribu*on – Why should we intervene?
Ensuring fairness by adjusFng the primary distribuFon of income or wealth
Two arguments:
• Pareto op0mality (a situa0on where no individual can be be\er off without making at least
one worse off) does not guarantee social jus0ce
• As efficiency-enhancing policies (e.g. fostering trade) makes losers, there is case for
compensa0ng them
In principle correc0ng income distribu0on could be done in a non-discre0onary way through lump-
sum transfers. In prac0ce imperfect informa0on and ins0tu0onal limita0ons prevent using them:
• Therefore, frequent equity-efficiency trade-offs exist. An equity-efficiency tradeoff occurs
when maximizing the produc0ve efficiency of the market leads to less equitable wealth
distribu0on
• Need for social-welfare criteria to help address trade-offs
• For policy maker it will not always be possible to have both goals in alloca0on as well ass
distribu0on realized at the same 0me
4
,Interdependence
The three key func0ons of economic policy are not truly independent (tradeoffs need to be made)
• Alloca0on -> Stabilisa0on
o E.g. qualita0ve ins0tu0ons may favour resilience to economic shocks
• Alloca0on -> Redistribu0on
o E.g. climate change policies may have major redistribu0ve effects (e.g. carbon tax)
• Stabilisa0on -> Alloca0on
o E.g. crea0ve destruc0on: recessions free resources that can be be\er employed
elsewhere
• Redistribu0on -> Alloca0on
o E.g. income redistribu0on may result in inac0vity traps
1.3. Discre6on versus rules
Should economic policy rely on discre*on or rules?
Discre0onary measures:
• Are those measures taken by policy decision-makers according to their own evalua0on and
on a basis case by case à ac0ve policy
• Offers more flexibility: the best policy response for the given circumstances
• Be\er when the economic environment is uncertain
Predetermined policy rules:
• Are instruments of economic policy put in force without the necessity of observing and
deciding on the basis case by case à more passive policy
• Policy follows a pre-specified plan
• Ac0ons of policymakers are more transparent and predicable (voordeel)
In most countries both are present
Time-inconsistent and *me-consistent policy
The problem of 0me consistency: arises whenever the effec0veness if a policy today depends on the
credibility to implement that policy in the future.
• A 0me consistent policy as one where a future policymaker lacks the opportunity or the
incen0ve to renege.
• Conversely, a policy lacks 0me consistency when a future policymaker has both the means
and the mo0va0on to break the commitment.
A 0me-inconsistent policy may make the public happy in the short run but will ul0mately fail to
produce the long-run policy goal.
• A 0me-consistent policy, in contrast, nails the long-run policy goal but does not make people
unhappy in the short run.
An example:
• The long-run goal of flood policy is to prevent building in floodplains. In the short run,
however, compassion dictates bailing out vic0ms, even those who failed to heed warnings.
Bailouts today are 0me-inconsistent (they implicitly encourage floodplain construc0on)
because people learn to watch what policymakers do (bail out vic0ms) and ignore what
policymakers say (build at your own risk). If, somehow, threats of no relief could be made
credible, people would think twice before temp0ng mother nature. And no floodplain
construc0on today means no need for flood relief tomorrow (a 0me-consistent outcome).
5
,2. Evalua:on and limits of economic policy making
Contributes fundamentally to sound public governance
Policy monitoring and evalua0on is crucial for:
• Understanding the links between policy interven0ons and their outcomes and impact
• Improving the design and implementa0on of economic policies
• Enhancing policies’ efficiency and effec0veness
• Enhancing accountability and transparency, and hence providing legi0macy for the use of
public funds and resources
Can cover a range of prac0ces:
• Some countries have adopted guidelines, or even a legal framework, for policy evalua0on
• Monitoring = ongoing, evalua0on = episodic
• Focus on programmes, plans, reforms,...
• Ex-ante or ex-post
• ORen done by na0onal Planning Bureau and by interna0onal organisa0ons (IMF Ar0cle IV,
OECD country reports, European Commission country specific recommenda0ons,...)
Methodologies and tools used
Each policy evalua0on system starts with systema0c data collec0on and data analysis/interpreta0on
(uncovering pa\erns and trends in datasets)
Models for policy evalua0on:
• Tradi0onal Keynesian macro-econometric models
• Dynamic Stochas0c General Equilibrium models
• Vector Auto-Regressive (VAR) models -...
Par0al analyses on impact (effec0veness: does a policy work?)
Process and outcome evalua0ons (efficiency: do the benefits overcome the costs?, was the policy
jus0fied?)
Example of the data you can focus on:
What is the general state of the economy?
– A SWOT of the Belgian economy
A picture on how economic policy
has worked
6
,2.1. The limits of economic policy
Informa0on problems:
• Data issues (e.g. economic data oRen become available with a delay or may be wrong)
• Policymakers do not have full access to informa0on and it is oRen used strategically by those
with access to it
• Model uncertainty (e.g. specifica0on, variables to be included, parameters es0mated with
uncertainty)
Lucas cri0que:
• Changes in economic policy will affect the behaviour of private agents (households, firms)
• Models that do not allow for agents to adjust their behaviour cannot be used for policy
Much debate over its effec0veness:
• Policy effec0veness depends on agents’ confidence: policy that is credible gains effec0veness
and vice versa
• Time inconsistency: situa0ons where, with the passing of 0me, policies that were determined
to be op0mal yesterday are no longer perceived to be op0mal today
Key factors influencing economic policy impact
1. The exis0ng state of the economy:
o The number and nature of exis0ng economic problems/imbalances
o The quality of ins0tu0ons (e.g., public administra0ons)
o E.g., implemen0ng tax cuts during a period of recession has a different impact
compared to when the economy is booming
2. Timing of policy implementa0on (“0ming is everything”):
o Effec0veness some0mes requires swiR policy ac0on
o E.g., policies to mi0gate the economic impact of COVID-19
3. Global economic condi0ons:
o A small open economy will strongly depend on external factors (e.g., interna0onal
business cycle, global interest rates,…). As a result, it will be more difficult for
economic policy to have a certain intended impact.
4. Other: learn from past experiences and from other countries’ policies, good understanding of
socioeconomic system, etc.
2.2. The limits of benevolence
PoliFcians someFmes deviate from general interest – Why do they do so?
Electoral cycles and par0san preferences:
• Policy makers oRen have strong electoral and par0san mo0va0ons regarding the degree,
nature and 0ming of economic policy ac0vity (e.g. they are less likely to increase taxes and
more likely to spend before elec0ons)
Re-elec0on mo0va0ons:
• Poli0cians’ main objec0ve may be to hang on to power and therefore to maximise their re-
elec0on chances
Pressure from special interest groups:
• Associa0ons of individuals or organisa0ons that on the basis of one or more shared concerns
a\empt to influence policy in its favour by lobbying members of the government
• May lead to favouring par0cular groups at the expense of public interest
• At the extreme: corrup0on and bribery
7
, 3. GDP: king of economic measurement, but only a (bad) proxy of human well-being
3.1. Economic policy in prac6cal terms
The ulFmate goal of economic policy is to promote the well-being of ciFzens
Opinions differ however as to what this general objec0ve entails in prac0ce.
• ARer all, well-being is a wide- ranging concept, which relates not only to material prosperity
(i.e. welfare, oRen expressed by GDP per capita) but also to personal developments and
equal opportuni0es, due care for the environment, and so on, making it harder to delineate
the precise, concrete objec0ve of economic policy.
The general objec0ve is some0mes equated with the pursuit of a sa0sfactory rate of ‘sustainable’
economic growth
• that is to say, growth that does not occur at the expense of the well-being of future
genera0ons (due to predatory exploita0on of the environment, for instance)
• or that is accompanied by a fair distribu0on of income and wealth within the popula0on.
From a macroeconomic perspec0ve, however, the goal of ‘sustainable’ growth is oRen taken to mean
‘balanced’ growth, in the sense of the absence of accumula0ng ‘imbalances’. The la\er implies:
1. Op0mum u0lisa0on of the labour supply (frequently referred to as ‘full employment’)
2. Price stability (low infla0on);
3. A stable balance of payments (no excessive current account deficit) and the associated
preserva0on of interna0onal compe00veness; and
4. Balanced public finances (essen0ally a sustainable public debt).
In prac0ce, however, these policy objec0ves occasionally clash or are inconsistent, making it hard to
achieve all of them at the same 0me.
• A policy conflict is a situa0on where one economic objec0ve is achieved at the cost of
another objec0ve.
• Rapid economic growth, for instance, goes along with nega0ve externali0es, like natural
resources deple0on, pollu0on, climate change, loss of biodiversity, etc.
• Moreover, it is frequently accompanied by a swiR rise in spending, which can translate into
sharp price increases, rising imports and a burgeoning balance of payments deficit.
o The financial crisis made it painfully clear, moreover, that strong economic growth is
not sustainable if it is accompanied by steadily rising debt levels, whether on the part
of government, businesses or households.
No0ce: policy objec0ves can also be complementary, meaning that achieving one economic
objec0ve will also assist in mee0ng another economic objec0ves
• e.g., economic growth and full employmen
GDP is ‘the king’ of economic measurement ...but not a par*cularly useful measure of human well-
being
Easterlin Paradox: ”Over 0me happiness does not trend upward as
income con0nues to grow”
• Maximising GDP = goal
• If GDP grows, happiness does not follows
• GDP doesn’t measure wellbeing
8
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