1 Lectures on Economic Policy Prague University of Economics Andreas Wörgötter,

2 What Applied Economics is about Bringing together three building blocks:  Data – Defining what to observe/monitor  Econometrics – extracting information which is in the data  Economic theory – “smart simplification” of driving forces behind economic activity The aim is to understand how the economy works and how to improve it

3 Applied Economics is an input for economic policy  Policy needs to be triggered by the observation that something is not working as it should – for instance high unemployment  Economic theory provides hints about the transmission mechanism between the policy instruments and the ultimate targets – for instance the impact of a tax cut on employment, output and unemployment  Econometrics provides quantitative estimates for the impact of policy measures – for instance the size of the multiplier

4 Government is the main client for applied economics  Results need to be robust  Trade-offs should be clearly indicated  Delicate balance between - relevance (which is determined by government priorities) - trust (which makes the economist an insider) - sophistication (limited by absorption capacity within the govt. administration) - independence (which helps avoiding capture)

5 How do we find out what is right and wrong?  Applied Economics is about human action. It is time specific and taking place in a social context. It is a social science  Experiments are only possible to a very limited extent  Economic theory can be right in a logical sense, but what is left open is the extent to which its conclusions are relevant  Data collection is a matter for itself.  Econometric methods can be more or less appropriate (as the debate about Reinhart-Rogoff shows).  It is therefore not possible to proof that a hypothesis is right, but only that it may be too likely that it is wrong (Popper’s falsification theorem) – which requires permanent effort

6 How to find the “right” economic advice?  Keep a critical mind, ask questions  Don’t believe in wonders  Look for international experience, learn from good and bad examples  Be cautious about excuses  Is the advice “replicable”?

7 The OECD Approach Economic Surveys  Bi-Annual for all member countries and key partners  Drafted by Secretariat experts in consultation with national administration  Intense discussions internally and externally  Special role for Committees with representatives from all member countries  Public presentation

8 Data – Basis Principles  Reliability  Timeliness  Comparability  Edward Leamer: Economics is about pattern finding and story telling – data should allow to find a pattern  OECD – principle of evidence based policy recommendations

9 Important data to watch - I  GDP – level, structure and growth  Issues: Seasonality, Weather and one-offs Purchasing Power Parity – catching up economies look poorer than they are Dutch Disease – structural change and terms of trade changes Boom/Bust – unsustainable indebtedness of households Pro-cyclicality of financial markets and fiscal policies Unbalanced growth and external imbalances – Germany Regional disparities – mobility and convergence

10 Important data to watch - II  When should government intervene?  The output gap – identifying the cyclical position of the economy: Output gap = actual output - potential output Potential output = what could be produced if all resources (labour and capital) are normally utilised 2 Measurement methodologies: production function approach smoothing (separating trend and cycle)

11 Important data to watch - III  Going beyond GDP – How’s life in the Czech Republic?  GDP (material basis for wellbeing) is important, but not everything

12 Czech Republic has a low income inequality

13 Which is a consequence of redistribution

14 Generating the lowest poverty risk

15 Econometrics  Statistics applied to economic data  Always start with looking at data  First think, then estimate  Avoid sample selection bias  Be open to robustness tests  Keep it simple

16 Economic Theory  Keynes – involuntary unemployment  Macroeconomics - SNA  Responsibility for smoothing cyclical development  The transmission mechanism – the multiplier  Questions I – how much is current consumption constrained by current income  Questions II – how distorting is expansionary fiscal policy  Questions III – What are consequences of quantitative easing

17 The Future of Applied Economics  The crisis is signalling the need and chance for change  Is more always better?  What is the relation between protection and innovation?