Institutions are the capital stock for policy-making. Institutions affect the production of policy in practice: how economic policy is made, how it is reviewed, and how it is implemented. What happens in practice can often be much different than what is described on paper. Economic actors see what happens in practice. Thus the nature of institutions is crucial for economic actors' assessments of policy credibility.
Institutional structures can constrain the policy options available to individual policy-makers or government organs. A horizontal separation of power among government organs, such as the separation of executive, legislative, and judicial organs, can ensuring that the policy-making process is subject to review and constraints from multiple centers of government power. Regular elections provide for a review of government actions and a possible temporal constraint on new policies. Bureaucratic and administrative hierarchies with distributed and circumscribed responsibilities foster decision-making inertia. By making major policy changes more difficult, institutional structure can promote the credibility of current policy.
The relationship between the fiscal authority and the central bank is a key component of the institutional structure of macroeconomic policy-making. If the central bank is subservient to the fiscal authority, the fiscal authority will be more able to secure monetary financing of a fiscal deficit. This makes a policy of price stability less credible. On the other hand, establishing an independent central bank, or strengthening the nominal independence of an existing central bank, can be an institutional expression of a commitment to price stability. A central bank that is strong enough to refuse to finance an imprudent fiscal deficit helps to deter such deficits from occurring.
Institutions are the means by which policy decisions are made effective. Policies without organizations capable and willing to implement them are not credible. Suppose, for example, that a leader decrees that peasant farmers will be granted ownership of the land that they farm. If that leader does not also set up institutions for registering titles to the land, for resolving conflicting land claims, and for facilitating the transfer of land among persons, the policy of giving land to the peasants is less credible. Similarly, a policy to promote competition in telecommunications is less credible if its implementation is entrusted to the ministry that runs the existing telecommunications monopoly.
Policy Credibility Learning Module