The process of economic policy formulation can range from a very democratic, participatory process to a process that is closed, secret, and dictatorial. Nonetheless, in a vibrant economy individuals will always make economically significant choices. Individuals' choices depend on their expectations of what economic policy will be. These expectations depend not only on what the government declares economic policy to be, but also on history, culture, and economic and political logic. Differences between the economic actors' expectations regarding economic policy and the government's policy plans can greatly affect economic outcomes. Consider the following scenario:

An imaginary country called Economia produces agricultural commodities and consumer goods. Economia currently has a 50% tariff on imported consumer goods. With such a tariff Economia does not import or export agricultural commodities or consumer goods and thus achieves a traditional policy goal of self-sufficiency. A new Minister of Finance proposes abolishing the import tariff on the grounds that doing so will foster a more efficient allocation of economic resources. Given the poor record of economic development in Economia, the President of Economia, who had previously supported the import tariff, reluctantly agrees to try the Minister of Finance's plan.

The President of Economia announces that import tariffs will be cut from 50% to 0%. Entrepreneurs, who decide whether to invest their time, effort, and material resources in producing import-competing goods or exportables, have to judge what tariff policy will be over the next five years in order to decide what they will do.

The first column in the table below shows entrepreneurs' judgement of what the tariff rate will be over the next five years. The second column shows the benefits, given entrepreneurs's policy expectations, if the government reduces tariffs to zero. The benefits are expressed as a percentage of the full benefits that would be realized if entrepreneurs believed that tariffs would be reduced to zero.

As is apparent from the simple example above, the benefits from pursuing a particular economic policy rise as entrepreneurs' beliefs about economic policy become closer to the policy that is actually pursued. Convincing entrepreneurs, and more generally the public, that a particular type of economic policy will be pursued must be an important consideration in policy-making.

Questions

• How do you do the model calculations above?
• What issues affect whether the public believes the government's announced policy?

Policy Credibility Learning Module