The Theory of Optimal Economic Policies

A General Equilibrium Analysis

Abstract

It is well established in the case of a small country that the optimal tool for a given target is the one which is directly aimed at the target. For instance, production subsidy is the best policy for protecting a domestic industry. The theory must be, however, modified substantially from the viewpoint of an open economy with enough market power to affect its terms of trade. In this paper we reconsider the theory of optimal policies for given targets within the framework of a standard two-country general equilibrium model of international trade.