Handbook of Econometrics Vols1-5 _ Chapter 35 pdf

ECONOMIC POLICY FORMATION: THEORY AND THE PUBLIC SECTOR LAWRENCE R.. For purposes of exposition, two types of policy will be examined, 1 overall macro policies, and 2 specific structura

ECONOMIC POLICY FORMATION: THEORY AND

THE PUBLIC SECTOR)

LAWRENCE R KLEIN

University of Pennsylvaniu

Contents

Appendix: An outline of a combined (Keynes-Leontief)

Hundhook of Econometrics, Volume III, Edited by Z Griliches and M.D Intriliguior

0 Elsevier Science Publishers B V, 1986

2058 L R Klan

1 Some contemporary policy issues

Mainstream economic policy, known basically as demand management, and its econometric implementation are jointly under debate now The main criticism comes from monetarists, who focus on versions of the quantity theo_ry of money, from advocates of the theory of rational expectations, and more recently from supply side economists All these criticisms will be considered in this paper, as well as the criticisms of public policy makers, who are always looking for precision in their choice procedures, even when the subject matter is inherently stochastic and relatively “noisy”

Demand management is usually identified as Keynesian economic policy, i.e as the type that is inspired by the aggregative Keynesian model of effective demand Also, the mainstream econometric models are called Keynesian type models; so the present state of world wide stagflation is frequently attributed to the use of Keynesian econometric models for the implementation of Keynesian policies These are popular and not scientific views In this presentation the objective will be to put policy measures in a more general perspective, only some of which are purely demand management and aggregative Also, the evolution of econo- metric models for policy application to many supply-side characteristics will be stressed To a certain extent, the orientation will be towards experience derived from the application of U.S models to U.S economic policy, but the issue and methods to be discussed will be more general

For purposes of exposition, two types of policy will be examined, (1) overall

macro policies, and (2) specific structural policies Macro policies refer to tradi-

tional monetary and fiscal policies, principally of central governments, but the model applications to local government policies are also relevant As the world economy becomes more interdependent, more economies are recognizing their openness; therefore, trade/payments policies are also part of the complement known as macro policy

By structural policy I mean policies that are aimed at specific segments of the economy, specific groups of people, specific production sectors, distributions of aggregative magnitudes or markets Economists like to focus on macro policies because they have overall impacts and leave the distributive market process unaffected, able to do its seemingly efficient work Most economists look upon the free competitive market as an ideal and do not want to make specific policies that interfere with its smooth working They may, however, want to intervene with structural policy in order to preserve or guarantee the working of the idealized market process

Macro policies are quite familiar Monetary policy is carried out by the central bank and sometimes with a treasury ministry Also, the legislative branch of

Ch 35: Economic Policy Formation 2059

democratic governments influence or shape monetary policy Central executive offices of government also participate in the formation of monetary policy It is a many sided policy activity The principal policy instruments are bank reserves and discount rates Reserves may be controlled through open market operations

or the setting of reserve requirements Policies directed at the instrument levels have as objectives specified time paths of monetary aggregates or interest rates

At the present time, there is a great deal of interest in controlling monetary aggregates through control of reserves, but some countries continue to emphasize interest rate control through the discount window On the whole, monetary authorities tend to emphasize one approach or the other; i.e they try to control monetary aggregates along monetarist doctrinal lines or they try to control interest rates through discount policy, but in the spirit of a generalized approach

to economic policy there is no reason why central monetary authorities cannot have multiple targets through the medium of multiple instruments This approach along the lines of modern control theory will be exemplified below

Monetary policy is of particular importance because it can be changed on short notice, with little or no legislative delay It may be favored as a flexible policy but

is often constrained, in an open economy, by the balance of payments position and the consequent stability of the exchange value of a country’s currency Therefore, we might add a third kind of financial target, namely, an exchange value target Flexibility is thus restricted in an open economy Monetary policies that may seem appropriate for a given domestic situation may be constrained by a prevalent international situation

There are many monetary aggregates extending all the way from the monetary base, to checking accounts, to savings accounts, to liquid money market instru- ments, to more general credit instruments The credit instruments may also be distinguished between private and public sectors of issuance The plethora of monetary aggregates has posed problems, both for the implementation of policy and for the structure of econometric models used in that connection The various aggregates all behave differently with respect to reserves and the monetary base The authorities may be able to control these latter concepts quite well, but the targets of interest all react differently Furthermore, monetary aggregates are not necessarily being targeted because of their inherent interest but because they are thought to be related to nominal income aggregates and the general price level The more relevant the monetary aggregate for influencing income and the price level, the more difficult is it to control it through the instruments that the authorities can effect

Benjamin Friedman has found, for the United States, that the most relevant aggregate in the sense of having a stable velocity coefficient is total credit, but this

is the least controllable.’ The most controllable aggregate, currency plus checking

‘Benjamin Friedman, “The Relative Stability of Money and Credit ‘Velocities’ in the United States: Evidence and Some Speculations”, National Bureau of Economic Research, working paper No

accounts, has the most variable velocity Between these extremes it appears that the further is the aggregate from control, the less variable is its associated velocity This is more a problem for the implementation of monetary policy that for the construction of models

But a problem for both policy formation and modeling is the recent introduc- tion of new monetary instruments and technical changes in the operation of credit markets Electronic banking, the use of credit cards, the issuance of more sophisticated securities to the average citizen are all innovations that befuddle the monetary authorities and the econometrician Authorities find that new instru- ments are practically outside their control for protracted periods of time, espe- cially when they are first introduced They upset traditional patterns of seasonal variation and generally enlarge the bands of uncertainty that are associated with policy measures They are problematic for econometricians because they establish new modes of behavior and have little observational experience on which to base sample estimates

Side by side with monetary policy goes the conduct of fiscal policy For many years - during and after the Great Depression-fiscal policy was central as far as macro policy was concerned It was only when interest rates got significantly above depression floor levels that monetary policy was actively used and shown to

be fairly powerful

Fiscal policy is usually, but not necessarily, less flexible than monetary policy because both the legislative and executive branches of government must approve major changes in public revenues and expenditures In a parliamentary system, a government cannot survive unless its fiscal policy is approved by parliament, but this very process frequently delays effective policy implementation In a legislative system of the American type, a lack of agreement may not bring down a government, but it may seriously delay the implementation of policy On the other hand, central banking authorities can intervene in the functioning of financial markets on a moment’s notice

On the side of fiscal policy, there are two major kinds of instruments, public spending and taxing Although taxing is less flexible than monetary management,

it is considerably more flexible than are many kinds of expenditure policy In connection with expenditures, it is useful to distinguish between purchases of goods or services and transfer payments The latter are often as flexible as many kinds of taxation instruments

It is generally safer to focus on tax instruments and pay somewhat less attention to expenditure policy Tax changes have the flexibility of being made retroactive when desirable This can be done with some expenditures, but not all Tax changes can be made effective right after enactment Expenditure changes, for goods or services, especially if they are increases, can be long in the complete making Appropriate projects must be designed, approved, and executed Often it

is difficult to find or construct appropriate large projects

Tax policy can be spread among several alternatives such as personal direct taxes, (either income or expenditure) business income taxes, or indirect taxes At present, much interest attaches to indirect taxes because of their ease of collec- tion, if increases are being contemplated, or because of their immediate effect on price indexes, if decreases are in order Those taxes that are levied by local, as opposed to national governments, are difficult to include in national economic analysis because of their diversity of form, status, and amount

Some tax policies are general, affecting most people or most sectors of the economy all at once But, speci$c, in contrast to general, taxes are important for the implementation of structural policies An expenditure tax focuses on stimulat- ing personal savings Special depreciation allowances or investment tax credits aim at stimulating private fixed capital formation Special allowances for R&D, scientific research, or capital gains are advocated as important for helping the process of entrepreneurial innovation in high technology or venture capital lines These structural policies are frequently cited in present discussions of industrial policy

A favorite proposal for strictly anti-inflationary policy is the linkage of tax changes, either as rewards (cuts) or penalties (increases), to compliance by businesses and households with prescribed wage/price guidelines Few have ever been successfully applied on a broad continuing scale, but this approach, known

as incomes policies, social contracts, or TIPS (tax based incomes policies), is widely discussed in the scholarly literature

These monetary and fiscal policies are the conventional macro instruments of overall policies They are important and powerful; they must be included in any government’s policy spectrum, but are they adequate to deal with the challenge of contemporary problems? Do they deal effectively with such problems as:

-severe unemployment among certain designated demographic groups;

-delivery of energy;

-conservation of energy;

-protection of the environment;

-public health and safety;

-provision of adequate agricultural supply;

-maintenance of healthy trade balance?

Structural policies, as distinct from macro policies, seem to be called for in order

to deal effectively with these specific issues

If these are the kinds of problems that economic policy makers face, it is worthwhile considering the kinds of policy decisions with instruments that have

to be used in order to address these issues appropriately, and consider the kind of economic model that would be useful in this connection

For dealing with youth unemployment and related structural problems in labor markets, the relevant policies are minimum wage legislation, skill training grants, and provision of vocational education These are typical things that ought to be done to reduce youth unemployment These policy actions require legislative support with either executive or legislative initiative

In the case of energy policy, the requisite actions are concerned with pricing of fuels, rules for fuel allocation, controls on imports, protection of the terrain against excessive exploitation These are specific structural issues and will be scarcely touched by macro policies These energy issues also effect the environ- ment, but there are additional considerations that arise from non-energy sources Tax and other punitive measures must be implemented in order to protect the environment, but, at the same time, monitor the economic costs involved The same is true for policies to protect public health and safety These structural policies need to be implemented but not without due regard to costs that have serious inflationary consequences The whole area of public regulation of enter- prise is under scrutiny at the present time, not only for the advantages that might

be rendered, but also for the fostering of competition, raising incentives, and containing cost elements It is not a standard procedure to consider the associated inflationary content of regulatory policy

Ever since the large harvest failures of the first half of the 1970s (1972 and

1975, especially) economists have become aware of the fact that special attention must be paid to agriculture in order to insure a basic flow of supplies and moderation in world price movements Appropriate policies involve acreage limitations (or expansions), crop subsidies, export licenses, import quotas, and similar specific measures They all have bearing on general inflation problems through the medium of food prices, as components of consumer price indexes, and of imports on trade balances

Overall trade policy is mainly guided by the high minded principle of fostering

of conditions for the achievement of multilateral free trade This is a macro concept, on average, and has had recent manifestation in the implementation of the “Tokyo Round” of tariff reductions, together with pleas for moderation of non-tariff barriers to trade Nevertheless, there are many specific breaches of the principle, and specific protectionist policies are again a matter of concern Trade policy, whether it is liberal or protectionist, will actually be implemented through

a set of structural measures It might mean aggressive marketing in search of export sales, provision of credit facilities, improved port/storage facilities, and a whole group of related policy actions that will, in the eyes of each country by itself, help to preserve or improve its net export position

We see then that economic policy properly understood in the context of economic problems of the day goes far beyond the macro setting of tax rates, overall expenditure levels, or establishing growth rates for some monetary aggre- gates It is a complex network of specific measures, decrees, regulations (or their

absence), and recommendations coming from all branches of the public sector In many cases they require government coordination Bureaus, offices, departments, ministries, head of state, and an untold number of public bodies participate in this process It does not look at all like the simple target-instrument approach of macroeconomics, yet macroeconometric modeling, if pursued at the appropriate level of detail, does have much to contribute That will be the subject of sections

of this paper that follow

2 Formal political economy

The preceding section has just described the issues and actors in a very summary outline Let us now examine some of the underlying doctrine The translation of economic theory into policy is as old as our subject, but the modern formalism is conveniently dated from the Keynesian Reuolution Clear distinction should be made between Keynesian theory and Keynesian policy, but as far as macro policy

is concerned, it derives from Keynesian theory

The principal thrust of Keynesian theory was that savings-investment balance

at full employment would be achieved through adjustment of the aggregative activity level of the economy It was interpreted, at an early stage, in a framework

of interest-inelastic investment and interest-elastic demand for cash This particu- lar view and setting gave a secondary role to monetary policy Direct effects on the spending or activity stream were most readily achieved through fiscal policy, either adding or subtracting directly from the flow of activity through public spending or affecting it indirectly through changes in taxation Thinking therefore centered around the achievement of balance in the economy, at full employment,

by the appropriate choice of fiscal measures In a formal sense, let us consider the simple model

C=f(Y-T) consumption function

where

G = public expenditures

A = time difference operator

Y= total output (or income, or activity level)

Fiscal policy means the choice of an appropriate value of t (tax rate), or level G (expenditure), or mixture of both in order to achieve a target level of Y This could also be a dynamic policy, by searching for achievement of a target path of

Y through time To complement dynamic policy it is important to work with a

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richer dynamic specification of the economic model Lag distributions of Y-T or

AY in the C and I function would be appropriate This kind of thinking inspired the approach to fiscal policy that began in the 1930’s and still prevails today It inspired thoughts about “fine tuning” or “steering” an economic system It is obviously terribly simplified It surely contains grains of truth, but what are the deficiencies?

In the first place, there is no explicit treatment of the price level or inflation rate

in this system Arguments against Keynesian policy pointed out the in!ationary dangers from the outset These dangers were minimal during the 1930’s and did not become apparent on a widespread basis for about 30 years-after much successful application of fiscal policy, based on some monetary policy as time wore on There is no doubt, however, that explicit analysis of price formation and great attention to the inflation problem must be guiding principles for policy formation from this time forward

Another argument against literal acceptance of this version of crude Keynesianism is that it deals with unrealistic, simplistic concepts Fiscal action is not directed towards “t ” or “G” Fiscal action deals with complicated al- lowances, exemptions, bracket rates, capital gains taxation, value added taxation, expenditures for military hardware, agricultural subsidies, food stamps, aid to dependent children, and unemployment insurance benefits These specific policy instruments have implications for the broad, general concepts represented by “t ” and “G “, but results can be quite misleading in making a translation from realistic to such macro theoretical concepts The system used here for illustration

is so simplified that there is no distinction between direct and indirect taxes or between personal and business taxes

The Keynesian model of income determination can be extended to cover the pricing mechanism, labor input, labor supply, unemployment, wages, and mone- tary phenomena There is a difference, however, between monetary analysis and monetarism Just as the simple Keynesian model serves as the background for doctrinaire Keynesian fiscal policy, there is another polar position, namely, the monetarist model which goes beyond the thought that money matters, to the extreme that says that only money matters The monetarist model has its simplest and crudest exposition in the following equation of exchange

Mv=Y

For a steady, parametric, value of v (velocity), there is a linear proportional correspondence between M (nominal money supply) and Y (nominal value of aggregate production or income) For every different M-concept, say M,, we would have *

MiV, = Y

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A search for a desired subscript i may attach great importance to the correspond- ing stability of ui It is my experience, for example, that in the United States, u2 is more stable than ut

More sophisticated concepts would be

M is a function of long run price as well as long run real income (X) In these relationships no attention is paid to subscripts for M, because the theory would

be similar (not identical) for any M, and proponents of monetarist policy simply argue that a stable relationship should be found for the authorities for some Mi concept, and that they should stick to it

The distributed lag relationships in P_; and X_i are evidently significant generalizations of the crude quantity theory, but in a more general view, the principal thing that monetarists need for policy implementation of their theory is

a stable demand function for money If this stable function depends also on interest rates (in lag distributions), the theory can be only partial, and analysis

then falls back on the kind of mainstream general macroeconometric model used

in applications that are widely criticized by strict monetarists.3

The policy implications of the strict monetarist approach are clear and are, indeed, put forward as arguments for minimal policy intervention The propo- nents are generally against activist fiscal policy except possibly for purposes of indexing when price movements get out of hand According to the basic monetarist

3 The lack of applicability of the monetarist type relationship, even generalized dynamically, to the United Kingdom is forcefully demonstrated by D F Hendry and N R Ericsson, “Assertion without Empirical Basis: An Econometric Appraisal of Friedman and Schwartz’ ‘Monetary Trends in the United Kingdom,“’ Monetary Trends in the United Kingdom, Bank of England Panel of Academic

relationship, a rule should be established for the growth rate of M according to the growth rate of Y, preferably the long run concept of Y A steady growth of

M, according to this rule, obviates the need for frequent intervention and leaves the economy to follow natural economic forces This is a macro rule, in the extreme, and the monetarists would generally look for the competitive market economy to make all the necessary micro adjustments without personal interven- tion

The theory for the steady growth of M and Y also serves as a theory for inllation policy, for if the competitive economy maintains long run real income (ZZw,X_ j) at its full capacity level-not in every period, but on average over the cycle- then steady growth of M implies a steady level for long run price (EqiPpi) The monetarist rule is actually intended as a policy rule for inflation control

There are several lines of argument against this seemingly attractive policy for minimal intervention except at the most aggregative level, letting the free play of competitive forces do the main work of guiding the economy in detail In the first place there is a real problem in defining M,, as discussed already in the previous

section Banking and credit technology is rapidly changing The various M,

concepts are presently quite fluid, and there is no clear indication as to which M,

to attempt to control To choose the most tractable concept is not necessarily going to lead to the best economic policy

Not only are the Mi concepts under debate, but the measurement of any one of them is quite uncertain Coverage of reporting banks, the sudden resort to new sources of funds (Euro-currency markets, e.g.), the attempts to live with inflation, and other disturbing factors have lead to very significant measurement errors, indicated in part at least by wide swings in data revision of various M, series If

the monetary authorities do not know M, with any great precision, how can they

hit target values with the precision that is assumed by monetarists? It was previously remarked that policy makers do not actually choose values for “t ” and

“G “ Similarly, they do not choose values for “M,“ They engage in open market

buying and selling of government securities; they fix reserve requirements for specific deposits or specific classes of banks; they fix the discount rate and they make a variety of micro decisions about banking practices In a fractional reserve system, there is a money multiplier connecting the reserve base that is controlled

by monetary authorities to M,, but the multiplier concept is undergoing great structural change at the present time, and authorities do not seem to be able to hit

M, targets well

A fundamental problem with either the Keynesian or the monetarist view of formal political economy is that they are based on simple models -models that are useful for expository analysis but inadequate to meet the tasks of economic policy These simple models do not give a faithful representation of the economy; they do not explicitly involve the appropriate levels of action; they do not take

account of enough processes in the economy Imagine running the economy according to a strict monetarist rule or fine tuning applications of tax policy in the face of world shortages in energy markets and failing to take appropriate action simply because there are no energy parameters or energy processes in the expository system This, in fact, is what people from the polar camps have said at various times in the past few years

What is the appropriate model, if neither the Keynesian nor the monetarist models are appropriate? An eclectic view is at the base of this presentation Some would argue against eclecticism on a priori grounds as being too diffuse, but it may be that an eclectic view is necessary in order to get an adequate model approximation to the complicated modern economy Energy, agriculture, foreign trade, exchange rates, the spectrum of prices, the spectrum of interest rates, demography, and many other things must be taken into account simultaneously This cannot be done except through the medium of large scale models These systems are far different in scope and method from either of the polar cases They have fiscal and monetary sectors, but they have many other sectors and many other policy options too

As a general principle, I am arguing against the formulation of economic policy through the medium of small models-anything fewer than 25 simultaneous equations Small models are inherently unable to deal with the demands for economic policy formation An appropriate large-scale model can, in my opinion,

be used in the policy process An adequate system is not likely to be in the neighborhood of 25 equations, however It is likely to have more than 100 equations, and many in use today have more than 500-1000 equations The actual size will depend on the country, its openness, its data system, its variability, and other factors The largest systems in regular use have about 5000 equations, and there is an upper limit set by manageability.4

It is difficult to present such a large system in compact display, but it is revealing to lay out its sectors:

Consumer demand

Fixed capital formation

Inventory accumulation

Foreign trade

Public spending on goods and services

Production of goods and services

Labor supply and demography

Income formation

Money supply and credit

Interest rate determination

Tax receipts

Transfer payments

Inter industry production flows

In each of these sectors, there are several subsectors, some by type of product, some by type of end use, some by age-sex-race, some by country of origin or destination, some by credit market instrument, and some by level of government The production sector may have a complete input-output system embedded in the model Systems like these should not be classified as either Keynesian or monetarist They are truly eclectic and are better viewed as approximations to the true but unknown Walrasian structure of the economy These approximations are not unique The whole process of model building is in a state of flux because at any time when one generational system is being used, another, better approxima- tion to reality is being prepared The outline of the equation structure for a system combining input-output relations with a macro model of income de- termination and final demand, is given in the appendix

The next section will deal with the concrete policy making process through the medium of large scale models actually in use They do not govern the policy process on an automatic basis, but they play a definite role This is what this presentation is attempting to show

There is, however, a new school of thought, arguing that economic policy will not get far in actual application because the smart population will counter public officials’ policies, thus nullifying their effects On occasion, this school of thought, called the rational expectations school, indicate that they think that the use of macroeconometric models to guide policy is vacuous, but on closer examination their argument is seen to be directed at any activist policy, whether through the model medium or not

The argument, briefly put, of the rational expectations school is that economic agents (household, firms, and institutions) have the same information about economic performance as the public authorities and any action by the latter, on the basis of their information has already been anticipated and will simply lead to re-action by economic agents that will nullify the policy initiatives of the authorities On occasion, it has been assumed that the hypothetical parameters of economic models are functions of policy variables and will change in a particular way when policy variables are changed.5

‘R Lucas, “Econometric Policy Evaluation: A Critique,” The Phillips Curve und Labor Mm-km,

Referring to a linear expression of the consumption function in the simple Keynesian model, they would assume

C=(u+fi(Y-T)

P=B(CG)

This argument seems to me to be highly contrived It is true that a generalization

of the typical model from fixed to variable parameters appears to be very promising, but there is little evidence that the generalization should make the coefficients depend in such a special way on exogeneous instrument variables The thought that economic models should be written in terms of the agent’s perceptions of variables on the basis of their interpretation of history is sound The earliest model building attempts proceeded from this premise and introduced lag distributions and various proxies to relate strategic parameter values, to information at the disposal of both economic agents and public authorities, but they did not make the blind intellectual jump to the conclusion that perceptions

of the public at large and authorities are the same It is well known that the public, at any time, holds widely dispersed views about anticipations for the economy Many do not have sophisticated perceptions and do not share the perceptions of public authorities Many do not have the qualifications or facilities

to make detailed analysis of latest information or history of the economy

Econometric models are based on theories and estimates of the way people do behave, not on the way they ought to behave under the conditions of some hypothesized decision making rules In this respect, many models currently in use, contain data and variables on expressed expectations, i.e those expected values that can be ascertained from sample surveys In an interesting paper dealing with business price expectations, de Leeuw and McKelvey find that statistical evidence

on expected prices contradict the hypothesis of rationality, as one might expect.6 The rise of the rational expectations school is associated with an assertion that the mainstream model, probably meaning the Keynesian model, has failed during the 1970s It principally failed because of its inability to cope with a situation in which there are rising rates of inflation and rising rates of unemployment In standard analysis the two ought to be inversely related, but recently they have been positively related Charging that macroeconomic models have failed in this situation, Lucas and Sargent, exponents of the school of rational expectations, seek an equilibrium business cycle model consisting of optimizing behavior by

‘F de Leeuw and M McKelvey, “Price Expectations by Business Firms,” Brookings Papers on Economic Activity, 1981) 299-314 The findings in this article have been extended, and they now report that there is evidence in support of long run la& of bias in price expectations, a necessary but not sutlicient condition for rationality of price expectations See “Price Expectations of Business

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economic agents and the clearing of markets.7 Many, if not most, macroecono- metric models are constructed piece-by-piece along these lines and have been for the past 30 or more years Rather than reject a whole body of analysis or demand wholly new modelling approaches, it may be more fruitful to look more carefully

at the eclectic model that has, in fact, been in use for some time If such models have appropriate allowance for supply side disturbances, they can do quite well in interpreting the events of the 1970s and even anticipated them in many instances.’

3 Some policy projections

Rather than move in the direction of the school of rational expectations, I suggest that we turn from the oversimplified model and the highly aggregative policy instruments to the eclectic system that has large supply side content, together with conventional demand side analysis and examine structural as well as macro policies

In the 1960s aggregative policies of Keynesian demand management worked very well The 1964 tax cut in the United States was a textbook example and refutes the claim of the rational expectations school that parametric shifts will nullify policy action It also refutes the idea that we know so little about the response pattern of the economy that we should refrain from activist policies Both the Wharton and Brookings Models were used for simulations of the 1964 tax cut.’ A typical policy simulation with the Wharton Model is shown in the accompanying table

This is a typical policy simulation with an econometric model, solving the system dynamically, with and without a policy implementation The results in the above table estimate that the policy added about $10 billion (1958 $) to real GNP and sacrificed about $7 billion in tax revenues Actually, by 1965, the expansion

of the (income) tax base brought revenues back to their pre-tax cut position The Full Employment Act of 1946 in the United States was the legislation giving rise to the establishment of the Council of Economic Advisers Similar commitments of other governments in the era following World War II and reconstruction led to the formulation of aggregative policies of demand manage-

‘Robert S Lucas and Thomas J Sargent, “After Keynesian Macroeconomics”, After the Phillips Cuwe: Persistence of High Inflation and High Unemployment (Boston: Federal Reserve Bank of Boston, 1978) 49-72

‘L R Klein “The Longevity of Economic Theory”, Quantitative WirtschaJf~/orschuilg, ed by H Albach et al (Tubingen: J C B Mohr (Paul Siebeck), 1977) 411-19; “Supply Side Constraints in Demand Oriented Systems: An Interpretation of the Oil Crisis”, ZeitschriJt Jiir Nationaliikonomie, 34 (1974) 45-56: “Five-year Experience of Linking National Econometric Models and of Forecasting International Trade”, Quanritatioe Studies of International Economic Relations H Glejser, ed (Amsterdam: North-Holland, 1976) l-24

‘L R Klein, “Econometric Analysis of the Tax Cut of 1964,” The Brookmgs Model: Some Furrher

Table 1 Comparative simulations of the tax cut of 1964 (The Wharton Model)

Real GNP (bill 1958 $)

The Wharton Annual Model is of the Keynes-Leontief type It combines a model of income generation and final demand determination with a complete input-output system of 65 sectors and a great deal of demographic detail It is described in general terms in the preceding section and laid out in equation form

in the appendix To show how some structural policies for medium term analysis work out in this system, I have prepared a table with a baseline projection for the 1980s together with an alternative simulation in which the investment tax credit has been increased (doubled to 1982 and raised by one-third thereafter), in order

to stimulate capital formation, general personal income taxes have been reduced

by about 6% and a tax has been placed on gasoline (5Oe per gallon).” To offset the gasoline tax on consumers, sales taxes have been cut back, with some grants in aid to state and local governments increased to offset the revenue loss of the sales taxes

These policies mix aggregative fiscal measures with some structural measures to get at the Nation’s energy problem Also, tax changes have been directed specifically at investment in order to improve the growth of productivity and hold down inflation for the medium term It is an interesting policy scenario because it simultaneously includes both stimulative and restrictive measures Also, it aims to steer the economy in a particular direction towards energy conservation and inducement of productivity

As the figures in Table 2 show, the policy simulation produces results that induce more real output, at a lower price level Lower unemployment accompa-

“The investment tax credit provides tax relief to business, figured as a percentage of an equipment

Table 2 Estimated policy projections of the Wharton Annual Model 1980-89

(Deviation of policy simulation from baseline) Selected economic indicators

A cutback in energy use, as a result of the higher gasoline tax, results in a lower BTU/GNP ratio This holds back energy imports and makes the trade balance slightly better in the policy alternative case

A contributing factor to the productivity increase is the higher rate of capital formation in the policy alternative There are no surprises in this example The results come out as one would guess on the basis of a priori analysis, but the main contribution of the econometric approach is to try to quantify the outcome and provide a basis for net assessment of both the positive and negative sides of the policy Also, the differences from the base-line case are not very large Economet- ric models generally project moderate gains To some extent, they underestimate

change in a systematic way, but they also suggest that the present inflationary situation is deep seated and will not be markedly cured all at once by the range of policies that is being considered

4 The theory of economic policy

The framework introduced by Tinbergen is the most fruitful starting point.” He proposed the designation of two kinds of variables, targets and instruments, A

target is an endogenous (dependent) variable in a multivariate-multiequation representation of the economy An instrument is an exogenous (independent) variable that is controlled or influenced by policy making authorities in order to lead the economy to targets Not all endogenous variables are targets; not all exogenous variables are instruments

In the large eclectic model, with more than 500 endogenous variables, policy makers cannot possible comprehend the fine movements in all such magnitudes Some systems in use have thousands of endogenous variables At the national economy level, top policy makers may want to focus on the following: GDP growth rate, overall inflation rate, trade balance, exchange rate, unemployment rate, interest rate There may be intermediate or intervening targets, too, as in our energy policy today - to reduce the volume of oil imports This is partly a goal on its own, but partly a means of improving the exchange value of the dollar, the trade balance, and the inflation rate There may be layers of targets in recursive fashion, and in this way policy makers can extend the scope of variables considered as targets, but it is not practical to extend the scope much beyond 10 targets or so This refers to policy makers at the top Elsewhere in the economy, different ministers or executives are looking at a number of more specialized targets-traffic safety, agricultural yield, size of welfare rolls, number of housing completions, etc

The large scale eclectic model has many hundreds or thousands of equations with an equal number of endogenous variables, but there will also be many exogenous variables A crude rule of thumb might be that there are about as many exogenous as endogenous variables in an econometric model.12 Perhaps we are too lax in theory building and resign ourselves to accept too many variables in the exogenous category because we have not undertaken the task of explaining them All government spending variables and all demographic variables, for example, are not exogenous, yet they are often not explicitly modeled, but are left

to be explained by the political scientist and sociologist This practice is rapidly changing Many variables that were formerly accepted as exogenous are now being given explicit and careful endogenous explanation in carefully designed additional equations; nevertheless, there remains a large number of exogenous variables in the eclectic, large scale model There are, at least, hundreds

Only a few of the many exogenous variables are suitable for consideration as instruments In the first place, public authorities cannot effectively control very many at once Just as coordinated thought processes can comprehend only a few targets at a time, so can they comprehend only a few instruments at a time Moreover, some exogenous variables cannot, in principle, be controlled effec-

12The Wharton Quarterly Model (1980) has 432 stochastic equations, 568 identities, and 401 exogenous variables The Wharton Annual Model (1980) had 647 stochastic equations, 948 identities and 626 exogenous variables Exclusive of identities, (and input-output relations) these each have approximate balance between endogenous and exogenous variables

tively The many dimensions of weather and climate that are so important for determining agricultural output are the clearest examples of non-controllable exogenous variables -with or without cloud seeding

The econometric model within which these concepts are being considered will

be written as

F( Y’, Y’- l y'_,, x’x’_, xlq,w’wI_l wI,, z’, Z’_l, z),, 0’) = e 0)

F = column vector of functions:

y = column vector of target (endogenous) variables:

x = column vector of non-target (endogenous) variables:

Xl-$, , XR2

n,+n,=n

w = column vector of instrument (exogenous) variables:

z = column vector of non-instrument (exogenous) variables:

zi, z 7_, , Z m,

m,+m,=m

0 = column vector of parameters

e = column vector of errors:

In this system, there are n stochastic equations, with unknown coefficients, in n

endogenous variables and m exogenous variables A subset of the endogenous

variables will be targets (nl I n), and a subset of the exogenous variables will be

instruments (m, 5 m)

The parameters are unknown, but estimated by the statistician from observable data or a priori information The estimated values will be denoted by 6 Also, for any application situation, values must be assigned to the random variables e Either the assumed mean (E(e) = 0) will be assigned, or values of e will be