Credibility of Economic Policy

Target Compatibility

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Economic policy must pursue compatible targets in order to be credible. The laws of arithmetic and the laws of economics put constraints on what policy is feasible. Infeasible policies cannot be implemented. Any economic agent that recognizes a government policy to be infeasible knows that that policy will not be carried out.

Consider the following simple example. A government proposes to increase government spending, reduce taxes, and reduce the government budget deficit. These policies are not credible. Increasing government spending and reducing taxes are targets that are likely to increase the government budget deficit. That result is incompatible with the announced intention to reduce the government budget deficit. Persons who recognize these facts will recognized that the announced government policy will not be implemented.

Target incompatibility can take subtle forms and recognizing it may require considerable experience and sophistication. What set of policy targets are feasible is often a contentious issue and incompatible policies may be apparent only in hindsight. On the other hand, capital markets recognize that policy reversals or collapses often present large profit opportunities. Thus there is often a large incentive for capital market participants to uncover incompatible policies.

Policy Credibility Learning Module