Policy instruments are economic variables that (1) stand in a cause-effect relation to the intermediate targets and (2) that the government can directly control.
What theory says is again crucial. If interest rates are your intermediate target some theories tell you that open market transactions are a possible instrument. They meet condition (1) because the theory says that such transactions will influence interest rates. They meet condition (2) because monetary authorities (the Federal Open Market Committee [FOMC] in New York City) can actually buy and sell government securities on the open market, pushing the nominal interest rates down or up. (The Fed has direct control of open market transactions because it has a large portfolio of bonds that it can sell, and the means to buy bonds from the market if it wants to.)
Concept Check 1: Monetarists want the Fed to maintain a constant money growth. Identify their ultimate goals, intermediate target and policy instrument in that policy.
Answer Concept Check 1: The money supply is the intermediate target of such a monetarist policy. The main policy instrument to accomplish a constant money growth is open market transactions. The ultimate goals are the usual ones: high growth, low inflation, low unemployment, stability.
Types of policies are defined by their instruments:
A fiscal policy uses the instrument of government budget, in particular changes in the level of taxes and government spending;
A monetary policy exploits instruments in the money market such as open market transactions, the discount rate, and foreign currency transactions.
An institutional policy uses as instrument the changes in laws, Federal programs of subsidy and taxation, and trade, labor, or capital regulations that might affect macro variables.
The distinctions allow overlap. Fiscal and institutional policies interact with monetary policies, intentionally or not. When the government sets up wage subsidy programs for unemployed workers with the intent to lower total unemployment, it is first an institutional policy, because it involves creating a new institution. But the policy has also a fiscal side-effect, since (in the first instance) it requires additional government spending. An institutional policy will change the rules of the game. A Federal Reserve Bank that does not think about monetary policy when it hears that unemployment is going down would not be doing its job-or so say the Keynesians. A monetarist doesn't care about the unemployment program. And that confirms our point: theory chooses both instruments and targets.
Concept check 2: The government lowers corporate taxes to boost profits in an effort to increase aggregate supply. Would you call this an institutional or a fiscal policy? (Answer at the end of chapter.)
Answer concept check 2: It could be both. You might consider the change in corporate taxes a fiscal policy because it lowers taxes to boost production. It also could be an institutional policy if the main intent is a change in the tax rules with resulting change in the level of taxes a side-effect.