1. Chapter 19 Macroeconomics 8e Froyen
Policy
Chapter 19
Macroeconomics 8e
Froyen

2. Loss Function and Public Choice
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.

3. Partisan Theory
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:
The liberal party emphasizes full employment and income redistribution;
The conservative party values price stability most highly.

4. Partisan Theory (2)
Partisan theorists argue that the voting patterns of liberals and conservatives are predictable:
If the liberal party gets into power, then:
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.
If the conservative party gets into power, then:
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.

5. 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

6. 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.

7. 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.

8. Cost-Benefit Analysis
Public Choice Analysis:
Cost-Benefit Analysis
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.

9. When the System Doesn’t Work Well
Public Choice Analysis:
When the System Doesn’t Work Well
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.

10. When the System Doesn’t Work Well (2)
Public Choice Analysis:
When the System Doesn’t Work Well (2)
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.

11. Public Choice Analysis: Deficit Bias
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.

12. Public Choice Analysis: Myopia and Other Biases
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.
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.

13. Efficiency Losses Public Choice Analysis:
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.

14. Efficiency Losses (2) Public Choice Analysis:
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.

15. Public Choice Analysis: Economics of Redistribution
There are three major reasons why large-scale 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.

16. Fiscal Policy
There are three variables with which the government can potentially control the economy to achieve macroeconomic goals:
Government Spending on Goods and Services (G)
Government Transfer Payments
Taxes

17. Automatic Stabilizers
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.
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.

18. Balanced Budget Rules
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.

19. Cyclical vs. Structural Deficits
The cyclical deficit is the portion of the federal deficit that result from GDP falling below the expected level.
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.
It is planned.