How to evaluate in Economics

As most students will be well aware, the skill of evaluation is key to gaining high marks in economics exams. In simple terms, to evaluate in economics means to consider the value of something (an explanation, theory or policy) in terms of whether it achieves an objective or provides an effective explanation.

The scope of evaluation

Almost anything can be evaluated in economics, including economic problems (how significant are they?) what causes the problem (is problem ‘X’ caused more by ‘A’ than ‘B’?) theories (how well do they explain problem ‘X’?), and policies (how effective would policy ‘Y’ be in reducing problem ‘X’?).


How to evaluate?

Evaluation techniques

There are several ways to approach evaluation, and techniques to use, including:

  • Time lags

  • Cost of implementation

  • Unintended consequences

  • Insufficient information

  • The current ‘context’

  • Extent of the problem

  • Breaking the ceteris paribus rule

  • Alternatives - Would a different policy do a better job?

  • Question the assumptions

  • Providing a weighted conclusion

Given time constraints in an examination, it may not be possible to cover all these elements.


Examples

Unemployment

Lets apply this list to a specific question on unemployment.

Q. To what extent can fiscal policy achieve reductions in unemployment?

  • Time lags

Discretionary fiscal policy is not easy to change – often only once a year in a budget – hence time lags between identifying rising unemployment, confirming it statistically, deciding the specifics of the policy, implementing the policy, monitoring the effects – can take many months, if not years.

This creates the ‘changed goalpost’ effect – by the time the policy kicks in, unemployment may have fallen anyway!

  • Cost of implementation

Fiscal policy is likely to mean increasing government spending. How much is spent depends on the nature of the policy – if the policy involves an injection of spending into social capital projects (road building, hospitals, schools etc) many billions of pounds or dollars may need to be spent with no guarantee of effectiveness.

The ‘cost’ of implementation also includes ‘opportunity cost’ – what else could have been done with the resources used?

  • Unintended consequences

In implementing a fiscal expansion there is the possibility that other economic problems may get worse. Inflation may increase, as might a worsening of the trade balance. Also, if capital projects are the chosen methods, negative externalities relating to building and construction work may be created.

  • Insufficient information

It is unlikely that policy makers will have perfect knowledge regarding the extent of unemployment, its causes of unemployment and the precise effects of a policy decision. For example, the true number of unemployed may be higher or lower than the official figure, and hence the specific policy may be inappropriate.

  • The current ‘context’

The context for policy decisions is always significant – shortly before the Covid pandemic took hold, unemployment was at an historic low, hence trying to reduce it further through a fiscal stimulus might be particularly difficult as any unemployment is likely to be structural rather than cyclical. However, following the impact of the pandemic, unemployment is high and a fiscal stimulus is likely to have a much greater effect. Policies can only be fully judged with respect to the 'current' context.

  • Extent of the problem

Again, the extent of the problem should also inform policy decisions. In this case, how high is the level of unemployment in terms of the historic long term trend? How long has the current episode been?

  • Breaking the ceteris paribus rule

If policy makers introduce a fiscal stimulus it is important to know what other variables that cannot be controlled could change to mitigate against the policy – for example, a fiscal stimulus might be less effective if at the same time exchange rates rise – this is likely to reduce export demand and cause a loss of jobs. In reality other things ‘do not stay unchanged’ – such as exchange rates, interest rates, consumer and business confidence.

  • Alternatives - would a different policy do a better job?

There is always an alternative policy to consider. Would a monetary stimulus do a better job? Although supply-side policy takes a long time to work and is often very costly, it might lead to a more sustainable reduction in unemployment.

  • Question the assumptions

This particular question on unemployment 'contains' several assumptions. Perhaps the most important one is that unemployment is not 'self-correcting' - is intervention actually required at all - will unemployment automatically fall if left alone?

There is also the assumption that unemployment is a problem - could it be argued that some level of unemployment is 'functional' in that it provides an incentive for those unemployed to re-skill or re-train? This may not be a very convincing argument, and it may not feature as a strong point, but it shows that you are prepared to evaluate.

  • A weighted conclusion

A fiscal stimulus is not without its problems and risks – the balance of evidence is that a fiscal stimulus can work in the medium term, despite the extended time lags, but it is unlikely to be sustainable in the long run. If supported with effective monetary policy, and supply-side reforms and projects then it is likely to be more effective.

Inflation

Q. To what extent will a rise in interest rates reduce inflationary pressure?

  • Time lags

Changing interest rates may take up to 18 months to have any effect on the price level.

  • Cost of implementation

However, changing interest rates is a simple process undertaken by a committee and can be made frequently, with few resources used.

  • Unintended consequences

There may be unintended consequences in terms of the negative effect of higher interest rates on long term investment.

  • Insufficient information

There is likely to be imperfect knowledge about the true level of inflation at any one time. Inflation is measured by tracking a basket of goods and services purchased by a 'typical' household in a given period of time. Given that the basket of goods is 'weighted' and is a sample from a limited number of outlets, it is entirely possible that a sudden rise in the price of a certain product is not reflected in the inflation 'numbers'. Similarly, it is not possible to make accurate predictions about the effects of a policy change.

  • The current ‘context’

As with all evaluation of economic policy, understanding the current context is important. For example, a question on the effect of an interest rate change on inflation must take the current interest and inflation rate into account, and how these rates compare with the long term average.

  • Extent of the problem

Inflation may be short lived, not excessive, and only caused by something temporary - such as a short term fall in the exchange rate.

  • Breaking the ceteris paribus rule

Interest rate policy on its own may not be effective, given that other factors can affect inflation and interest rates may have little effect (e.g. commodity shortages causing cost-push inflation).

  • Alternatives - would a different policy do a better job?

Inflationary pressure may be better reduced by a fiscal contraction, given interest rates are historically low, or more effective long term supply-side policies.

  • Question the assumption

Again, there is an assumption that inflation is a problem - while even a simple analysis will show why inflation is problematic, it can be argued that some level of inflation is beneficial if it encourages firms to increase production.

It should also be noted that in a market economy price changes are important in that they send signals to producers and consumers to change their behaviour, and reallocate their income or resources.

  • A weighted conclusion

Raising interest rates is not without its problems and risks – the balance of evidence is that a monetary tightening can work through its transmission mechanism, and despite time lags, may have the desired effect. However, it may need to supported by other policies, and there is no guarantee that changing interest rates works in all situations, such as inflation caused by a weaker exchange rate.

Make evaluation a habit

As I said at the beginning, almost anything can be evaluated in economics (and in life!). When you think like an economist you are constantly on the lookout to evaluate.

When to evaluate – at the end, or ‘during’?

Let’s say you have been asked to analyse how a policy might work – for example, how interest rates might be increased to reduce inflationary pressure.

You now have a choice – to evaluate at the end of your analysis, or to evaluate ‘as you go’.

It makes a lot of sense to evaluate after your analysis as it is simpler and you can draw all you points together in one evaluative conclusion.

However, evaluating as you go can also be useful, especially when examiners are looking out for your evaluation as soon as they start to mark your paper.

For example, if you suggest that an increase in interest rates works its way through the economy via a transmission mechanism you are now in a good position at this point in your answer to say ‘however, this can take up to 18 months to work’.

Once you have developed this point you can add another evaluation point that ‘however, increases in interest rates can have some unintended consequences’. By practicing this method, you are almost guaranteed to think in a more evaluative way.

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