Unit 1.2 Limits of Economic Policy

Question 1

Limits of knowledge - Economic policy

Answer 1

We enhance this function from 1.1: Yt = HI(Xt) → Yt = HI(Xt, Yt-1…, Yt-L, θ, εt)
Now, there’s a vector of parameters θ (e.g. elasticities), a series of L lags of the dependent variable (Yt-1…, Yt-L) and exogenous random shock ε.
Two issues:
1. Model uncertainty: How to choose the function H?
2. Parameter uncertainty: Limited data -> we dont really know θ

Question 2

Limits of representation - Economic Policy

Answer 2

Models based on historical data are flawed because they do not take into account the adaptive behaviour of economic agents to policies.
E.g., public spending rises -> agents might expect higher future taxes

Question 3

Limits of credibility - Economic Policy

Answer 3

• When expectations are rational, economic policy can become inefficient if the government wants to mislead private agents
  -E.g. the ‘surprise inflation’ trick that allows a non-visible real wage decrease and hence a raise in employment. But if workers know that, the ‘policy’ will no longer work as they will demand according nominal wage increase to keep real wage from falling

Question 4

Limits of Information - Economic policy

Answer 4

The limits of information in economics refer to the challenge of not having perfect information, leading to issues like the agency problem, where the interests of the person assigned a task (agent) may not align perfectly with the interests of the people assigning the task (principal). This can affect various relationships, from shareholders and entrepreneurs to voters and politicians.

Question 5

Limits of benevolence - Economic policy

Answer 5

Politicians might depart from the general voter interest for various reasons such as:
1. Lack of credibility: Politicians have limited time in office and worry about losing popularity or their position. This can make them hesitant to implement long-term beneficial policies if they are not immediately popular.
2. Pressure from interest groups: Politicians can be influenced by specific groups who push for their own interests, which might not be good for everyone.
3. Motivated by re-election
4. Ethics of conviction: Politicians may also make decisions based on their party’s beliefs, even if those decisions don’t align with what would be best for the majority.

Question 6

What is the ‘Median Voter’ theory:

Answer 6

In politics, this theory suggests that voters will choose the candidate whose views are closet to their own. If you think fo political views as a line with extreme views on each end, candidates have an incentive to move their position towards the middle to appeal to more voters. As a result, politicians often end up with very similar positions, especially on key issues.

Question 7

Interdependence definition

Answer 7

In today’s world, its not just one government or country that makes all the decisions or controls everything. Instead, different levels of government and different countries influence each other.
Different levels and types of interdependence:
1. Supranational Entities: These are like groups of countries working together on certain issues
2. Decentralisation at the subnational level: Instead of just the central government making all decisions, local areas like regions have more control over what happens in their area.
3. Openness: this is about how much what happens in one country is affected by what happens in other countries

Question 8

Types of Openness - Interdependence

Answer 8

1. Trade openness: The amount of buying and selling a country does with other countries (X+M)/(2*GDP)
2. Financial openness: This is about the flow of money across borders, like investments. (A&L)/(2*GDP)
3. Migration: Movement of people between countries

Question 8

Interdependence Consequences

Answer 8

1. Fiscal expansion: When a government increases spending or reduces taxes, this leads to people having more money to spend (boost in consumption, C) and buying more things from abroad (increase in imports, IM). When your country buys more from other countries, it helps those countries because your imports are their exports (IM is neighbour’s X).
2. Monetary expansion: When a country’s central bank lowers interest rates (monetary expansion) it makes borrowing cheaper. This can lead to people in neighbouring countries moving their money to your country.
3. Border effect and home bias:
   Despite the ease of trading or investing across borders, there’s still a tendency for people and businesses to prefer doing thins within their own country. This is the ‘border effect’ or ‘home bias’. For example in the EU, trade within a country is much more common than trade with other countries - 10 times as much on average