Sunday, February 17, 2013

Fiscal policy reaction functions

There is considerable discussion in the economic literature, including the more popular literature (like certain blogs) of a policy reaction function of central banks to economic variables, like the "Taylor rule(s)". Not all governments, however, have recourse to monetary policy, which leaves fiscal policy to, perhaps, take up the function(s) normally set for monetary policy. If the policy instrument under investigation were not the interest rates and other measures controlled or influenced by the central bank, but the revenues and expenditures of the government, can one still speak of policy reaction functions?

It seems that the only logical answer is yes. There are two types of policy reaction functions that ought to be considered for analysis (at least that come readily to mind): (1) empirical policy reaction functions and (2) optimal policy reaction functions. By empirical, I simply mean the policy reaction that seems to occur coincident with relevant macroeconomic variables, like inflation, the output gap, etc. As such, there is no assumption that the right decision is made, although, if the government is made up of good planners, it should align closely with the best policy (in what universe that is, one can speculate). The other is perhaps more difficult. Whereas the first can be considered based on crude aggregates, etc., the optimal policy should come from a more concrete model of behavior, which might be microfounded or not, and, if it is, it could be based on a real business cycle or a new keynesian model. So basically the main difference between these two policy reaction functions are that one is just based on what is seen happening and the other is theoretically based.

Need there be such a strong distinction? I am not sure that there does. After all, the empirical policy reaction function can be more refined into a model of political bargaining which conforms, more or less, to an economic theoretical model, including such things as rational self-interest, different models of informational asymmetry, etc. My guess is that if one were to closely examine policy-making, one would find that where small but deeply interested parties are on one side and large but diffusely interested parties are on the other, the smaller group may be able to exert outsized influence.

This may be a partial explanation why the top 2% or so have been able to hold onto their tax cuts, even when many in the 98% recognize that this may eventually affect all taxpayers. It remains a puzzle why a major party would be so uncompromising about the interests of such a small minority.

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