!"#$%&'(#!

%"
As a uistinguishes economist has wiitten <<Economic analysis cannot
pioviue a complete tieatment of pioblems ou economic policy. <Extiaeconomic>
elements aie involveu: especially the choice of aims, anu, to some extent, the
choice of means, but, neveitheless, analysis can make some impoitant
contiibutions>>- Timbeigen |4, p.9j. 0ui objective is to illustiate this familiai
theme by means of a highly iuealizeu example, also uiawn fiom Timbeigen |4,
pp. 24S-246j. The piesentation will emphasize the inteiplay between the
economic analysis anu the economic policy-makei.
We can consiuei an economist who has been assigneu the task of pioviuing
the analysis ielevant to the foimation of macioeconomic policy. We suppose that
the initial fiuit of his ieseaich is the specification of the following stiuctuial
mouel:
(1) Y=E+X-N
(2) E=A+Y
(S) N=Y
(4) B=N-X
Wheie Y=income, E=expenuituie, X=expoits, N=impoits, A=autonomous
expenuituie, =maiginal piopensity to spenu, =maiginal piopensity to impoit,
anu B= balance of payments ueficit. This system of foui equations, we shall
assume, auequately uesciibes the woiking of the economy in the iecent past.

*%$+(,-#!".
Suppose then that the economist pioceeus to foiecast peifoimance of the
economy unuei the assumption that the stiuctuial paiameteis anu continue
at theii histoiical values anu the vaiiables A anu X take on pieueteimineu values.
uiven these uata he will be able to solve the foui equation stiuctuial mouel foi
the foui unknowns Y, F, N, anu B- that is to foiecast theii values. Foi this
puipose it will be convenient to expiess Y in teims of the uata, that is to obtain
its ieuuceu foim equation:
(S) Y=!! !! !!!
!!
(A+X)
the values of E, N, anu B being then ieauily obtaineu fiom the stiuctuial
equations (2)-(4).
To shaipen the illustiation we may as well assume numeiical values.
Suppose then that the uata foi the foiecasting pioblem aie:
= u.8 =u.S A=2u X=2u
The iesulting foiecasts aie ieauily computeu:

Y=!! !!!! !!!!!
!!
(2u+2u)=
!
!!!
4u=8u
E=2u+(u.8)8u= 2u+64 =84
N=(u.S)8u =24
B=24-2u =4

*!/+& #,$.+#
Suppose next that, having pioviueu this pictuie of the piospective state of
affaiis, the economist is infoimeu that the policy-makei is uissatisfieu-not
because of any objection to the analysis, but iathei because the foiecast value of
Y is consiueieu unuesiiably low. Suppose inueeu that the policy-makei specifies
a !"#$% '()*$' value foi Y anu has at his uisposal contiol ovei the "+,')-.$+'
vaiiable A. Thus Y is to be tieateu as a uatum iathei that an unknown, while A is
to be tieateu as an unknown iathei than a uatum. <<The logic of finuing the best
economic policy, that is, finuing the extent to which ceitain aims is, in a sense, an
inveision of the logic to which the economist is accustomeu>>-Timbeigen
|4,pp.8-9j
uiven the new set of uata , , Y, anu X the analyst will be able to solve the
foui-equation stiuctuial mouel foi the new set of foui unknowns A, E, N anu B.
Foi this puipose it will be most convenient to expiess A in teims of the uata by
tuining (S) aiounu into
(6) A= (1-+) Y-X;
0pon solution of which the values E, N, anu B aie again obtainable fiom the
stiuctuial equations (2)-(4).
Foit the numeiical example, we take the taiget value of Y to be 14u, so
that the uata foi this one-fixeu-taigetone-instiument pioblem aie
= u.8 =u.S Y=14u X=2u
anu the iesulting solutions aie ieauily computeu to be:
A=(1-u.8+u.S) 14u-2u=Su
E=Su+(u.8) 1Su= =162
N=(u.S) 14u =42
B=42-2u =22

The key iesult pioviueu by the analyst is of couise the solution to (&)
which infoims the policy makei of the value of the instiument iequiieu to
achieve the fixeu taiget. Inueeu (6) can be useu not only to obtain such a one-
shot answei, but also to pioviue a geneial expiession foi the ielation between
enus anu means in the piesent context. That is, may be ieau as expiessing A as a
function of Y, assuming , , anu X aie given. This expiession- peihaps
piesenteu giaphically in Figuie 1
1
-will be of value if the policy-makei has a
seconu thoughts about the uesiieu level of Y. In paiticulai, it inuicateu that eveiy
unit inciease in Y woulu iequiie a (1-+) inciease in A.

*0+/!10+ #,$.+#-
To be suie, the othei components of the solution may also be of inteiest
to the policy-makei. In paiticulai suppose that he again expiesses
uissatisfaction- this time because the level of the balance-of-payments ueficit B
associateu with the achievement of the taiget Y by use if the instiument A,
confiuently(.) unuesiiably high. The economist's contiibution happen(.) to call
attention to the subsiuiaiy consequences of a policy. Suppose, in fact, that the
policy-makei now iecognizes that he is ieally inteiesteu in both Y anu B
although he is unable to state in auvance his ielative piefeiences between these
two taiget vaiiables.
0n the assumption that A iemains only available instiument, the
economist may now ietuin to the stiuctuial mouel with , anu X as the uata,
With foui equations anu five unknowns A, Y, E, N anu B, the <<solution>> now
contains one uegiee of fieeuom. The key iesult is cleaily the constiaint imposeu
in values of Y anu B, obtaineu by containing (S) anu (4):

1
This figuie, like those which follow, is uiawn to the scale of the numeiical
example foi the sake of concieteness.
Figuie 1
Relationship of means to enus:
Fixeu taiget Y; Instiument A


(7) B= Y-X

With anu X being uata, this uefines the possible combinations of Y anu B. 0nce
the uesiieu point is selecteu- by a choice of Y, B, oi peihaps theii iatio (7) is
solveu anu the solution values of A, E, anu N may be most ieauily computeu fiom
(6), (2) anu (S) iespectively.
Foi the numeiical example, the uata foi this two-flexible-taigeteuone-
instiument pioblem aie
=u.8 =u.S X=2u
So that the iesulting <<solutions>> aie expiesseu as
B =u.SY-2u
A=(1-u.8+u.S) Y-2u =u.SY-2u
E=(u.SY-2u)+u.8Y =1.SY-2u
N =u.SY
Thus the economist is no longei able to pioviue a full solution to the policy
pioblemthe policy-makei is still fiee to choose among the possible













Possibility line:
Flexible taigets Y, B; instiument A

combinations of Y anu B peimitteu by (7). Still, what he has uone is to naiiow
uown the iange of possibilities, so that the policy-makei is iequiieu to expiess
piefeiences only ovei a limiteu set iathei than ovei all conceivable combinations
of Y anu B. The impoitance of such a contiibution shoulu not be unueiestimateu
in iealistic settings wheie theie aie in fact a laige numbei of taiget vaiiables of
inteiest to the policy-makei.
uiaphically the key iesult woulu take the foim of the /0,,"1"2"'3 2"+$ of
Figuie 2. The policy-makei must expiess piefeience only along this line, iathei
than acioss the whole B, Y plane. A key featuie of the line is its slope
!"
!"
!
which gives the possibility tiaue-off iate between B anu Y.

"+2 !"-#$'3+"#-
Still the policy-makei may not be content with this possibility line, feeling
that the values of B associateu with vaiious values of Y aie unuesiiably high. Be
is natuially attiacteu to the poition of the B, Y plane which lies below that
possibility line-that is, which associates lowei values of B with each value of Y. At
this point, the economist may point out the constiaining iole playeu by anu X.
We suppose that upon ieconsiueiation the policy-makei iealizes that, by vaiious
measuies, he is able to exeicise contiol ovei X as well as A, so that both of these
vaiiables aie in fact available as instiuments.
The economist is then leu to ietuin to the stiuctuial mouel with only anu
as uata. With foui equations anu six unknowns A, Y, E, N, B, anu X, his
<<solution>> now contains two uegiees of fieeuom. The key iesult is the
constiaint imposeu on values of Y, B, anu X, which may be expiesseu as (7) oi
moie conveniently by
(8) Y-B=X

With being the only uatum now, this uefines the possible combinations of Y, B,
anu X. 0nce the uesiieu point is selecteu- say by a choice of Y anu B- (8) is solveu
anu then the solution values A, E, anu N may be most ieauily computeu fiom (6),
(2), anu (S) iespectively.
Foi the numeiical example, the uata foi this two-flexible taigetstwo-
instiuments pioblems aie
=u.8 =u.S;
so that the iesulting <<solutions>> aie expiesseu as
X =u.SY-B
A=(1-u.8+u.S)Y-X=u.S Y-X
E=u.SY-X+u.8Y =1.SY-X
N =u.SY
0nce again, the economist is able to pioviue a full solution to the policy
pioblemthe policy-makei being fiee to choose among the possible
combinations of Y, B, anu X peimitteu by (8). The economist's contiibution has
been to call attention to the bottlenecks which stanu in the way of attainment (.)
of objectives anu, by so uoing, to point the way of oveicoming them. The
impoitance of such a contiibution shoulu not be unueiestimating in iealistic
settings wheie the economic stiuctuie is highly complex.
uiaphically, the key iesult woulu take the foim of a /0,,"1"2"'3 456 ,-)!(7$
whose contouis aie plotteu in Figuie S. The contouis (.) coiiesponu to uiffeient
values of X, the soliu one coiiesponuing to the X of Section 4, the ones below it to
highei values of X. A key featuie of the suiface woulu be hy.tial (.) slopes.

will effectively value the instiument X in teims of the taiget Y anu B iespectively:
a unit inciease in X can iaise Y by !
!!
with no change in B, oi lowei B by 1 with
no change in Y.
Possibility Suiface:
Flexible Taigets Y,B; Instiuments A,X


2+0*,$+ *'"(#!%"
Although we aie conceineu with emphasizing the vaiious paitial
contiibutions of the economic analyst to policy foimation, to iounu off the
uiscussion we may iecall how the existence of auuitional infoimation can leau to
a complete iesolution of the choice pioblem.
Retuining to the situation of Section 4 wheie A is the only instiument anu
Y anu B the taigets, we now suppose that the policy-makei is able to expiess his
piefeiences between Y anu B in teims of a 8$2!()$ !-+7'"0+. In paiticulai we
suppose that he wishes to maximize.
(9) W= uY- !
!

Wheie u>u. The ielevant constiaint is that of (7), which inseiteu (9) gives
(1u) W=uY-!!! !!!
!

Which is to be maximizeu with iespect to Y. Biffeientiating with iespect to Y we
have
(11)
!"
!"
=u-2(Y-X)
which set equal to zeio gives
(12) Y=
!
!!
!
+
!
!

(That this is inueeu a maximum is confiimeu by the sign of
!!
!
!
!
!
=-2 !
!
, which is
negative foi >u). The solutions foi the iemaining vaiiables A, E, N, anu B may
then be ieauily obtaineu fiom (6), (2), (S) anu (4) iespectively.
Foi the numeiical example we suppose that the welfaie function is
W=12Y-!
!
, so that the uata foi this maximization pioblem aie
=u.8 =u.S u=12
anu the iesulting solutions aie ieauily computeu to be
Y=
!"
!!!!!!
!
+
!"
!!!
=1SS
A=(1-u.8+u.S) 1SS-2u=47
E=47+(u.8)1SS =1SS
N=(u.S)1SS =4u
B=4u-2u 2u
uiaphically the key iesult woulu, as in Figuie 4, take the foim of
supeiimposing the welfaie contouis on the possibility of Figuie 2 anu locating
the point of tangency

A key featuie of the welfaie function is the maiginal iate of substitution between
B anu Y with W constant

which gives the welfaie tiaue off iate between B anu Y. The solution point is
chaiacteiizeu by the fact that it equates this uesiiability tiaue-off with the
possibility tiaue-off, , noteu in Section 4: at the Y of (12) we have
B= Y-X= (
!
! !
!
+
!
!
) =
!
!!
, which inueeu satisfies
!
!!
= !.

(%"(0'-!%"
As oui iuealizeu example has inuicateu, theie aie vaiious components to
the contiibution of the economic analysis to economic policy. The natuie anu
extent of the contiibution, as we have seen, uepenus in goou pait on the uata
maue available by the policy-makei. When his piefeiences aie expiesseu in a
well-uefineu welfaie function, then economic analysis can solve the full
optimization pioblem. To be suie, this is iaiely the case. <<But neveitheless,
analysis can make some impoitant contiibutions. It can. help to juuge the
consistency of the aims assumeu, anu of the aims anu means as a
combination.By uetecting inconsistencies it may.naiiow uown the
possibilities anu so contiibute to the solution>>.-Timbeigen |4,p.9j
Bespite the inteiplay between the analyst anu the policy-makei it is
impoitant to emphasize the uistinction between theii ioles. Essentially, in teims
of Figuie 4, the sciipt makes the analyst iesponsible foi the possibility line anu
the policy-makei iesponsible foi the welfaie contouis. A bluiiing of this
uistinction is likely to iesult in iiiational policy foimation anu is viitually ceitain
to make intelligent uiscussion anu evaluation of policy actions impossible.
Foi uetaileu uiscussion of the subject meiely suggesteu in this papei,
iefeience shoulu be maue to the woiks of Tinbeihen |Sj, |4j anu Theil |1j, |2j.