A policy instrument may be defined as a means under the control of the government to change the behaviour of the economy. Among the important and common policy instruments are fiscal, monetary, trade, industrial, health and education policies. The legislative power of governments enables them to impose direct controls with the view to establishing the legal framework of economic activity. In the last category, exchange rate controls are sometimes shown but these are more often a part of monetary policy instruments.
At this point a few analytical distinctions, which are useful when discussing about policy instruments, may be mentioned. The first concerns their mode of operation. This draws attention to the important differences between instruments that affect the economy in a direct way and those that exert a largely indirect influence. Policy instruments which operate directly include government taxation and expenditures, direct control that regulate the quantity of import or place legal limit on prices and wages. Other legislative measures like nationalisation of industries, land reform, etc., also fall under this category. Direct measures, i.e., policy instruments in this category bypass the market mechanism and are often alternative to it. Most of the indirect policy instruments, on the other hand, are designed to achieve their desired results by altering the price signals in the market. Examples include attempts to discourage certain types of consumption through taxation, to encourage savings by raising interest rate and to encourage exports by depreciating exchange rate. Governments use both direct and indirect policy instruments and the balance between them has an important bearing on the resource allocation in an economy.
A different distinction arises from thinking about the type of impact that various instruments may have. The main difference here is between instruments whose impact is general and those whose impact is specific. Use of the overall budgetary balance, and variations in interest rate or in the rate of exchange are examples of instruments that have a general impact on the macro economy. By contrast, a tax on a particular commodity and the award of subsidy to an industry are examples of instruments that have specific incidence. Choices between these two types of instruments depend on the objectives of a policy. Yet another useful distinction is between an instrument and a change in value of the same. For example, the imposition of a tax on imported cloth, where no tax formerly existed, introduces a new policy instrument. But a change in the rate of existing tax on cloth represents a variation in the use of that instrument. In the same context, it can be convenient to differentiate between policies which are designed to bring about small changes in the economy and policies that alter the structure of the economy.
THE RELATIONSHIP BETWEEN OBJECTIVES AND POLICY INSTRUMENTS: There can be conflicting objectives facing a government. These objectives can be reconciled by using multiple policy instruments. This provides a convenient starting point for an exploration of the relationship between objectives and policy instruments.
Let us imagine a government that has only one objective, promotion of employment. It may undertake an investment programme for employment generation. This programme may require import of capital equipment, machinery and raw materials which may, in turn, create a deficit in the balance of payments. The government will then formulate a second objective, to reduce the payments deficit in the external account. The two objectives are now liable to come into a conflict. To resolve this, the government has to bring in one or more policy instruments. Thus, more objectives the government wishes to fulfill, the more instruments it will need to use.
In general, the ability of governments to achieve multiple objectives is a function of the number of policy instruments it employs for these purposes. Equally important, it is a function of the efficiency of the chosen instruments.
JAN TINBERGEN MODEL: The relationship between objectives and policy instruments can be formally stated with the help of the model or system developed by the Dutch economist Jan Tinbergen. This is a mathematical or quantitative approach to the selection of policy instruments but we will present it in a descriptive form. He placed all economic variables into two categories. First, there are target variables (called t-variables). These relate to such parameters as the level of employment, the rate of inflation, the growth of output, the distribution of income and other macro indicators. These are the variables a government is likely to be interested in but does not directly control. What the government can do is to set target value for these. The values of these targets are thus exogenously determined by the government. Policy instruments are the second type of variables and they are called instrument variables or policy variables (p-variables). The values of these are determined within the system and as such they are endogenous variables, or unknowns, because what values are placed on them will depend upon the values of the target variables. For instance, we cannot decide what the exchange rate should be until we know what targets have been set for imports and exports.
The system or model developed by Tinbergen has one equation for each target variables making y equations in all. Corresponding to this there are a total of z instrument variables. For the system/model to work the number of instrument variables must be equal to the number of target variables. For one unique solution z should be equal to y. If z is less than y it will not be possible to satisfy all the targets. A solution will thus require abandoning some targets or using more policy instruments.
The key conclusion of the simplified Tinbergen system/model is that for a government to achieve multiple objectives it must use at least as many policy instruments as the number of its policy objectives.
The simplified Tinbergen system/model should not be criticised because it simplifies. All models are abstraction, concentrating on essentials, reducing problems to manageable proportions. The appropriate question to be asked about a model is whether it oversimplifies or whether it simplifies successfully. If the mathematical or quantitative approach underlying Tinbergen model has limitations, it has strengths as well. First, it reveals the advantages of being precise and consistent about objectives. Secondly, the development of a model of the economy makes it easier to assess the range of feasible outcomes and lets the policy makers know whether their targets and policies are realistic or not. Thirdly, the quantitative approach encourages precision about the effects of a change in an instrument variable. Fourthly, the Tinbergen model provides an approach to the difficult task of reconciling conflicts between objectives by the use of carefully selected multiple policy instruments. The final strength, from the point of view of the advocates of 'growth with equity' strategy is that it is in conformity with the welfare optimising model.
An economy is riddled with various obstacles to the attainment of Pareto Optimality where no one gains without making someone worse off. Given these obstacles some general principles to guide policies in the direction of optimality are helpful. The Tinbergen model exactly does that. The results of theoretical research indicate that if there are a number of constraints preventing the satisfaction of optimality conditions it will not generally be desirable to have these conditions to hold in the rest of the economy. The conditions of Pareto Optimality only provides a basis for policy recommendations if they are all satisfied everywhere in the economy at the same time which is a practical impossibility. Theorists have put forward a corresponding set of general rules for second best solutions in real-world situations. Policy instruments chosen on their relevant efficiency to meet objective(s) can go a long way to meet the second-best solutions. Selecting the policy instrument can be based on common sense or experience or even through a trial and error method.
The Tinbergen model provides a theoretical underpinning to the selection of policy instruments with reference to objective(s) set by the government. It is not perfect as it simplifies complexity and abstracts from the real world. But as an attempt to resolve the issue of optimum policy instrument it can be pressed into service because the co-efficient expresses the relationship between an instrument variable (policy instrument-p variable) and a target variable (t variable) providing a measure of the power of a given change in the instrument to effect a consequential change in the target variable. The Tinbergen model suggests that other things being equal, the general rule should be to choose the more powerful instruments, the ones with the largest co-efficient. The acceptance of a policy change to the politicians will be related to the extent to which it is a break with the past. They will, therefore, opt for powerful instruments that need only modest manipulation to achieve desired results.