The document outlines the basic framework of the theory of economic policy, including the Tinbergen-Theil approach. It discusses Tinbergen's fixed targets approach and Theil's flexible target approach. It also mentions rational expectations and the Lucas critique, as well as the policy game approach. The document provides definitions and classifications that are important to the theory of economic policy, such as exogenous and endogenous variables, target variables, and irrelevant variables. It displays the basic framework using a scheme and discusses the model of the economic system and preferences of the policy-maker.

1. Theory of
Economic Policy
Dr. Mahmoud R. Fath-Allah
Economics Department
Faculty of Economics and Political Science
Cairo University
Mobile: 01006820651
Email: m.r.fathallah@gmail.com
Graduate Course
fall 2015

2. Contents:
- the basic framework of the theory of economic policy.
- Tinbergen-Theil approach:
- Tinbergen’s Fixed Targets Approach
- Theil’s flexible target approach
- Rational Expectations and Lucas Critique.
- the Policy Game approach

3. (b)“Irrelevant” variables: endogenous variables
which are not evaluated by the policy-maker
and express the side-effects of economic
policies.
The above classification makes use of two other
basic ingredients of the theory of economic policy
which are assumed to be given within this theory: the
model of the economic system and the preferences of
the policy-maker. On the one hand, the model of the
economic system describes the structure and the
objective function, which may be interpreted a
individual (for the policy-maker) or collec
(“social”) welfare, utility, or cost function, or by
incomplete scale, containing at least a most-prefe
value for each target variable (and possibly for s
policy instrument variables as well).
Following [8, p.21] and [9, p.58], the b
framework of the theory of economic policy can
displayed by the following scheme:
To be more specific, denote by U the set of possible
policy instruments, with U∈u , where u may (but
need not) be an element of some vector space. The
set U expresses institutional, political, physical, and
other constraints on the values of the policy
economic system. The set of endogenous variabl
is constrained by U, Z, and the model (the func
f(..)). In particular, when z is a stochastic varia
then x is stochastic, too, and for each u there
corresponding probability distribution over x. In
non-controlled
exogenous variables
irrelevant endogenous
variables
economic system
(model)
policy instruments target variables
preferences of the
policy-maker
the basic framework of the theory of economic policy
Source: Neck, Reinhard, 2009

4. (1)Exogenous variables: not explained by the model of the economic
system.
(a) Policy instruments: under the control of the policy-maker.
(b) Non-controlled: “data”, not controllable by the policy-maker.
(2) Endogenous variables: explained by the model of the economic
system.
(a) Target variables: considered as goals (evaluated) by the policy-
maker.
(b) “Irrelevant” variables: not evaluated by the policy-maker and
express the side-effects of economic
policies.

5. the model of the economic system and the
preferences of the policy-maker
the model of the economic system: the structure and
the functioning of the economy under consideration
Preferences of the policy- makers:
- explicit objective function (welfare, utility) or cost
function:
- individual (for the policy-maker).
- collective “social”.
- incomplete scale, containing at least: most-
preferred value for each target variable (and
possibly for some policy instrument variables as
well).

6. The Tinbergen-Theil approach
The classical approach to the theory of economic policy

7. The Tinbergen-Theil approach
“Tinbergen-Theil paradigm”
In the early 1950s he addressed in formal terms the issue of the
controllability of a fixed set of independent targets by a
policymaker facing a parametric context (i.e. facing an economy
represented by a system of linear equations) and endowed with
given instruments, he was able to state some well-known general
conditions for policy existence.

8. Tinbergen's Fixed Targets Approach
macroeconomic policy-making would consist of the following
steps:
(i) selecting 'adequate instruments' to achieve the targets;
(ii)formulating the connections between targets and instruments;
(iii) determining the quantitative values required for the
instruments.
The approach took as given:
(a)the structure of the economy;
(b)the target variables;
(c)the numerical values of the target variables;
(d)the nature of the instrument variables.

9. The Choice of Target Variables:
The usual target variables relate to the level of employment; the rate of change of the
price level; the balance of payments; and the rate of economic growth. These, however, can
be expressed in different ways and others are possible.
Peston (1982) expresses them as:
a) high, stable and increasing level of real income;
b) stable or slowly increasing prices;
c) balance of payments surplus;
d) full employment;
e) fair distribution of income among people and regions.
objectives may conflict with each other.
However, there may be other reasons for setting targets. For instance some writers suggests
that governments may set targets in order to:
(a) provide information to the private sector about likely government behaviour;
(b) influence inflationary expectations;
(c) constrain or discipline governments.

10. government has two targets: income Y* and consumption C*
Suppose that the economy can be modelled as the following:
Y = C + I + G
C = a + bY
I = I
by changing G it is possible to achieve targets for either Y or C but not
both simultaneously.
To do this a second instrument is needed e.g. a lump-sum tax (T):
C = a + b(Y - T) and
Y = (a - bT + I + G). 1/(1-b)
This allows both T and G to change. We may set the desired changes in Y
and C as Y* and C*.
Y* = [(-bT + G)/b]. 1/(1-b) (1)
C* = b(Y* - T) (2)
Example:
where:
I and G exogenous; Y and C endogenous.
G :the only instrument.

11. From (2) we can calculate:
C* = bY* - bT
T = Y* - (C*/b)
This gives us a value for T. We can then substitute it back into (1) to give us the
required change in G.
In this model we can go on to develop an income tax case with three
instruments: G, v (the marginal tax rate), and u (the tax exemption level):
Y = C + I + G
T = u + vY
C = a + b (Y-T) = a + b (Y - u - vY)
= a - bu + b(1-v) Y
I = I and Y = (a - bu + I + G)/[1 -b(1-v)]
With three instruments and two targets there will be a degree of freedom in the
system: one could either change u to achieve the desired level of C and then
change G to achieve the desired level of Y; or change v and then G.

12. a policymaker (Government) can reach any given
(fixed) set of independent target values by an
appropriate vector of instruments if and only if the
number of independent instruments is equal to, or
greater than, the number of targets.
how to deal with systems in which the number of
instruments is less than that of targets?
“non-Tinbergen” systems.
Tinbergen’s fixed target approach
Golden Rule (Tinbergen Theorem):

13. Henri Theil provided a solution for many of the issues that had been left unsolved in
the Tinbergen theory.
- policymaker should minimize a loss (or maximize a utility) function defined on the
relevant target variables, subject to constraints describing the responses of the
economy.
- overcame Tinbergen’s rigid distinction between targets and instruments, by
allowing the latter to be relevant in their own right (for example, where
policymakers have preferences over how the instruments should be used; or have
strong views over whether their use should be restricted to certain “acceptable”
values) and introducing them directly into the objective function.
- develop a theory of economic policy in a multi-period dynamic setting.
- introduced uncertainty into the model of the economy and the policy process with
an appeal to the principle of certainty equivalence.
- improvements and advances in the theory as to the existence, uniqueness and
design of economic policies.
- development of modern methods of control theory.
Theil’s flexible target approach
- solved a non-Tinbergen system.

14. governments are trying to solve a stochastic optimisation problem by
maximising an objective function subject to constraints implied by the
structure of the economy -given by the transformation curve
Theil’s flexible target approach
(Optimisation approach)
assume the existence of a social welfare function (SWF) which expresses
society's (or the government's) view of the relative importance of the
different objectives and the trade-offs that the government is prepared to
accept.

15. The problems associated with these approaches are:
(a) It is difficult to specify the preference functions of
policy makers;
(b) The approach assumes that deviations above or
below a target are equally bad;
(c) Such an approach may lead to undue caution in
terms of what is feasible (there is too much stress on
constraints);
(d) Policy makers don't behave in this way.

16. effectiveness of specific policy instruments (Not
concerned by Tinbergen-Theil)
an issue that has been raised more prominently in the
subsequent economics literature with reference to specific
policy problems; particularly in monetary policy, in fiscal
policy, and in other applications.
(Barro, 1974). A proposition of policy neutrality or policy
“invariance” was thus stated with regard to the two most widely
used macroeconomic policy instruments.
rational expectations (REs)1960s
ineffectiveness of monetary policyMilton Friedman, 1968
fiscal policy was considered ineffective as an
instrument for managing income levels
policy neutrality or policy “invariance”
(Barro, 1974)

17. effectiveness: An instrument is effective with respect to a target
variable if changes in the instrument determine changes in the
equilibrium value of that target; otherwise it is ineffective.
exogenous policy neutrality: Economic policy is neutral with
respect to a target variable, if all the instruments are ineffective
with respect to that target variable.
Definitions:
endogenous policy neutrality: Economic policy is neutral with
respect to a target variable yi , if its equilibrium value is not
affected by any change in policymaker’s preferences.

18. Controllability: A system is controllable if the Government can
determine the values of the target variables for any possible vector of
desired targets by choosing an appropriate policy (i.e. vector of
instruments).
Controllability and sub (partial) controllability:
if the matrix C is square and full rank, the system is controllable. This is
also the case of a rectangular matrix C with more columns
(instruments) than row (targets) and a rank equal to the number of rows.
By contrast, if C is a rectangular matrix with more rows than columns,
the system is not controllable and a flexible target approach should be
used.

19. Theory of Rational Expectations

20. Theory of Rational Expectations
● Expectations will be identical to optimal forecasts using all available information
expectation of the variable that is being forecast
= optimal forecast using all available information
e of
e
of
X X
X
X
=
=

21. Implications
● If there is a change in the way a variable moves, the way in which
expectations of the variable are formed will change as well
● The forecast errors of expectations will, on average, be zero and
cannot be predicted ahead of time

22. Econometric Policy Critique
● Econometric models are used to forecast
and to evaluate policy
● Lucas critique, based on rational expectations, argues that
policy evaluation should not be made with these models
– The way in which expectations are formed (the
relationship of expectations to past information)
changes when the behavior of forecasted variables
changes
– The public’s expectations about a policy will influence
the response to that policy

23. New Classical Macroeconomic Model
● All wages and prices are completely flexible with respect
to expected change in the price level
● Workers try to keep their real wages from falling when
they expect the price level to rise
● Anticipated policy has no effect on aggregate output and
unemployment
● Unanticipated policy does have an effect
● Policy ineffectiveness proposition

24. Short-run response to an expansionary policy
(a New classical Model)
Unanticipated anticipated

25. Less expansionary than expected
Short-run response to an expansionary policy
(a New classical Model)

26. Short-run response to an expansionary policy
(a New Keynesian Model)
Unanticipated anticipated

27. Implications for Policymakers
● Policymakers must understand public’s expectations to
know outcome of the policy.
● There may be beneficial effects from activist stabilization
policy
● Design policy rules so prices will remain stable
Designing the policy is NOT easy because the effect of
anticipated and unanticipated policy is very different

29. • Stabilization policy usually falls under the category of
anticipated policy
• Therefore, it is generally correctly anticipated through rational
expectations
• Systematic policies are useless
• Because of rational expectations, only “erroneous” (completely
unanticipated) changes in the money supply influence the level
of economic activity

30. 1. More aware of importance of expectations and
credibility
2. Lucas critique has caused most economists to doubt
use of conventional econometric models for policy
evaluation
3. Since effect of policy depends on expectations,
economists less activist
4. Policy effectiveness proposition not widely accepted,
most economists take intermediate position that activist
policy could be beneficial but is tough to design
Impact of Rational Expectations Revolution

31. ● Expectations formation will change when the behavior
of forecasted variables changes
● Effect of a policy depends critically on the public’s
expectations about that policy
● Empirical evidence on policy ineffectiveness proposition
is mixed
● Credibility is essential to the success of anti-inflation
policies
● Less fine-tuning and more stability
Impact of the
Rational Expectations Revolution

32. Tinbergen-type decision model is inconsistent with the
assumption of REs
private sector behaviour to be invariant to the policy vector itself
when the private sector has REs of future developments
the policymaker will lose control of the economic system,
existence of an equilibrium
X

33. The policy game approach

34. Strategic interactions between the private sector and the
policymaker then ensure that the REs of both are satisfied.
The policy game approach
Barro and Gordon (1983)
policy decision within a strategic context
modeling the behaviour of players by considering separate
but not independent optimisation problems.

35. a strategic game in which the leader moves first and then the
follower move sequentially.
Stackelberg equilibrium conditions:
- The leader must know ex ante that the follower observes its action.
- The follower must have no means of committing to a future non-Stackelberg follower
action and the leader must know this.
- if the 'follower' could commit to a Stackelberg leader action and the 'leader' knew this,
the leader's best response would be to play a Stackelberg follower action.
Stackelberg leadership model

36. - Private sector is leader and trades off real wages and employment
when setting the nominal wage rate.
- long run monetary neutrality as a result of the private sector
expectations of discretionary monetary policy
- the private sector forms REs and fully crowds out monetary
effects on real output.
A superior solution, for the public sector, would be to commit to a
certain rule.
Stackelberg game between central bank and private sector

37. - having induced favorable private sector expectations, the policymaker
would always be tempted to cheat and renege on his commitment,
- being aware of this possibility, the private sector would (in self-
defense) anticipate worse results; results that can be avoided only if
the temptation to cheat is balanced by a fear that the policymaker
might lose his reputation and no longer be able to act effectively if
this game of interactions with the private sector is repeated.

38. Two fundamental propositions that characterize the new
theory of economic policy:
Proposition 1 (ineffectiveness): If one (and only one) player satisfies
the golden rule, all the other players’policies are ineffective.
Proposition 2 (existence): Existence of the game equilibrium requires
that two or more players do not satisfy the golden rule (unless they
share the same target values).

39. Thank you