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Policy
Chapter 19
Macroeconomics 8e
Froyen
Loss Function and Public Choice
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Social Loss:
L = a1(U-U*)2 + a2(P% - P%*)2 + a3(Y%-Y%*)2 > 0
Objective is to minimize the loss function (hit
unemployment, inflation, and economic growth
objectives).
Voting Loss:
VL = c0 + c1(U-U*)2 + c2(P% - P%*)2 + c3(Y%-Y%*)2
VL represents votes lost resulting from
deviations of macroeconomic goal variables from
target levels.
Partisan Theory
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Politicians vote according to ideology (deeply
held beliefs).
Macroeconomic outcomes are the result of
ideologically motivated decisions by leaders of
different political parties. The parties represent
constituencies with different preferences
concerning macro variables.
In the most common partisan model, there is a
liberal and a conservative party:
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The liberal party emphasizes full employment and
income redistribution;
The conservative party values price stability most
highly.
Partisan Theory (2)
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Partisan theorists argue that the voting patterns
of liberals and conservatives are predictable:
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If the liberal party gets into power, then:
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If the conservative party gets into power, then:
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government spending will increase as politicians attempt
to stimulate demand (to ensure full employment) and as
they increase transfer payments to redistribute income.
The expansionary policies will usually lead to higher
inflation.
fiscal policy will become more restrictive as conservatives
seek to fight inflation,
leading to rising unemployment and perhaps a recession.
As the parties go in and out of power, party
cycles emerge in the economy.
Public Choice Analysis
-- applies the tools of economics to the political
process in order to provide insight concerning
how the process works.
• Self-interested behavior is present in both
market and political sectors.
• Political process can be viewed as a complex
exchange process involving:
• voter-taxpayers
• politicians
• bureaucrats
Public Choice Analysis:
Rational Ignorance Effect
• Voters will tend to support those candidates whom they
believe will provide them the most government services and
transfer benefits, net of personal costs.
• Rational Ignorance Effect:
-- Recognizing their vote is unlikely to be decisive, most
voters have little incentive to obtain information on issues
and alternative candidates.
• Because of the rational ignorance effect, voters will be
uninformed on many issues; such issues will not enter into
their decision making process.
Public Choice Analysis:
Politicians
The Politician is a “supplier”, the voter is a
“demander”.
• Political officials are interested in winning elections.
Just as profits are the lifeblood of the market
entrepreneur, votes are the lifeblood of the
politician.
• Rationally uninformed voters often must be
convinced to “want” a candidate.
Public Choice Analysis:
Cost-Benefit Analysis
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Other things constant, legislators will have a
strong incentive to support political actions that
provide voters with large total benefits relative to
costs.
• If a government project is really productive, it will
always be possible to allocate the project’s cost so that
all voters will gain.
• When voters pay in proportion to benefits received, all
voters will gain if the government action is productive
(and all will lose if it is unproductive.) Under these
circumstances, there is a harmony between good politics
and economic efficiency.
Public Choice Analysis:
When the System Doesn’t Work Well
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Special Interest Effect
• Special Interest Issue:
One that generates substantial personal benefits for
a small number of constituents while imposing a
small individual cost on a large number of other
voters.
• Interest group members will feel strongly about an
issue that provides them with substantial personal
benefits. Such issues will dominate their political
choices.
Public Choice Analysis:
When the System Doesn’t Work Well (2)
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Special Interest Effect
(cont.)
• In contrast, the voters bearing the cost of special-interest
legislation will often be uninformed on such an issue
because it exerts only a small impact on their personal
welfare and because they are unable to avoid the cost by
becoming better informed.
• Politicians have a strong incentive to favor special
interest even if action is inefficient.
Public Choice Analysis:
Deficit Bias
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Elected officials gain votes and voter approval by
spending public monies on projects that yield
visible benefits to their constituents.
The same elected officials lose votes and voter
approval by imposing taxes on their constituents.
As a result, politicians have a deficit bias—it
“pays” them to spend in excess of tax revenue.
The pre-Keynesian sensibility of balanced
budgets helped prevent politicians from such
activity.
Public Choice Analysis:
Myopia and Other Biases
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Voters are Myopic (Shortsightedness
Effect)
-- Issues that yield clearly defined current benefits
at the expense of future costs that are difficult
to identify.
Voter behavior is heavily influenced by the state of
the economy a few quarters before the election.
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Moreover, output and employment are more
important to voters than inflation.
Unemployment is more likely to result in vote
loss than inflation.
-- Hence there is an inflationary bias.
Public Choice Analysis:
Efficiency Losses
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Rent Seeking
-- Actions by individuals and interest groups
designed to restructure public policy in a
manner that will either directly or indirectly
redistribute more income to themselves.
• Widespread use of the taxing, spending, and regulatory
powers of government that favor some at the expense of
others will encourage rent seeking.
• Rent seeking moves resources away from productive
activities. The output of economies with substantial
amounts of rent seeking will fall below their potential.
Public Choice Analysis:
Efficiency Losses (2)
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Lack of Incentive for Operational Efficiency
• In the public sector, the absence of the profit motive
reduces the incentive of producers to keep costs low.
Neither is there a bankruptcy process capable of
weeding out inefficient producers.
• Public-sector managers are seldom in a position to gain
personally from measures that reduce costs.
• Because public officials and bureau managers spend
other people’s money, they are likely to be less
conscious of cost than they would be with their own
resources.
Public Choice Analysis:
Economics of Redistribution
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There are three major reasons why largescale redistribution will reduce the size of
the economic pie:
• When taxes take a larger share of one’s income, the
individual reward derived from hard work and productive
service is reduced.
• As public policy redistributes a larger share of income,
more resources will flow into wasteful rent seeking
activities.
• Higher taxes to finance income redistribution and an
expansion in rent-seeking will induce taxpayers to focus
less on income-producing activities, and more on actions to
protect their income.
Fiscal Policy
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There are three variables with which
the government can potentially
control the economy to achieve
macroeconomic goals:
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Government Spending on Goods and
Services (G)
Government Transfer Payments
Taxes
Automatic Stabilizers
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Automatic stabilizers are changes in taxes and
government transfer payments that occur without
any further intervention or decision making when
the level of income changes.
Because tax receipts rise and fall with income,
the tax system is an automatic stabilizer.
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As GDP falls, government takes less income away from
consumers in the form of taxes.
As GDP rises, government takes more.
Thus, in relative terms, the tax system stimulates the
economy in recessions and dampens it in expansions.
Regressive tax structures are even more strongly
stabilizing.
Balanced Budget Rules
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For the reasons outlined before (involving
inefficiencies and deficit biases), public
choice economists advocate a balanced
budget amendment or at least deficit
targets.
Keynesians and others who oppose such
rules or amendments argue that such
rules impede the stabilization role of fiscal
policy. They argue that sometimes we
need to run deficits.
Cyclical vs. Structural Deficits
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The cyclical deficit is the portion of the
federal deficit that result from GDP falling
below the expected level.
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It is unplanned.
The structural deficit is the portion of the
federal deficit that would exist even if the
economy were operating at its potential
level of output.
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It is planned.