L10 - Rational Partisan Theory and the Business Cycle

Question 1

What are some core assumptions about political business cycles?

Answer 1

1. Politicians are seeking office. that is they care primarily about holding office and choose policies that will maximise their chances of re-election
2. Voters have stable preferences over economic outcomes which are reflected in their voting behaviour
3. Elected politicians have control over policy instruments that influence macroeconomic outcomes

Question 2

What is the key hypothesis of theories on political business cycles?

Answer 2

• governments will use their control over the economy to improve their chances of re-election
• Since voters have well-established preferences for high real income, high growth, low unemployment and low inflation
• We should see incumbents trying to deliver these outcomes prior to each election
  
  • e.g. nearing election time, the current political party will use instruments to create a boom, thus raising their chances for re-election
    
    • Although they will have to pay the price of high inflation later –> opportunitistic economic behaviour
    • the Partisan Model deviates from this political opportunism and looks at a more rational business cycle

Question 3

What was Hibbs (1977) suggestion on the preferences of political parties?

Answer 3

• Hibbs (1977) suggests that in industrial democracies, left-wing parties prefer combinations of output and unemployment which differ systematically from those chosen by right-wing parties.
  
  • His analysis incorporated a form of exploitable trade-off between inflation and unemployment via the assumption of adaptive expectations.
  • Partisan influence (coming from the left or right of the political spectrum) on real economic activity was shown to have permanent effects.
  • Examples of right / left wing parties are the Republican / Democratic parties in the US, and the Conservative / Labour parties in the UK.
• Compared to right-wing parties, left-wing parties are typically assumed to be more willing to bear the costs of ináation in order to lower unemployment (thereby increasing economic growth).

Question 4

What has the development in economic theory told us about the trade off between inflation and unemployment?

Answer 4

• However, developments in economic theory from the 1960s onwards, coupled with the available empirical evidence, suggests that such a trade-off is not easily exploitable. This has implications with respect to our theoretical modelling strategy.

Question 5

What is background of Alesina and Rosenthal (2004): Rational Partisan Theory?

Answer 5

• Alesina and Rosenthal (2004) develop a similar model to Hibbs (1977) within a rational expectations framework.
• For this reason, the theory they develop is an example of what is know as rational partisan theory.
• The empirical predictions of their model are at odds with traditional political business cycle models (i.e., Nordhaus 1975):
  
  • Nordhaus’s model predicts that economic growth should be lower before an administration comes to power, irrespective of its political ideology –> opportuntistic economic behaviour so the party is re-elected
• In Alesina and Rosenthal (2004), the business cycle occurs due to the uncertainty generated by competitive partisan politics. –> not knowing who is going to be in power in politics - thus expectation of inflation will be a weighted average of the two parties prefered rates of inflation
• The model builds on the work of Barro and Gordon (1983), and draws heavily on the monetary policy games literature

Question 6

What is the equation for the stucture of the economy in Alesina and Rosenthal (2004)?

Answer 6

• can drop the time subscript as its not really a dynamic model
• (3) looks like a Lucas Supply Curve (Phillips Curve?)

Question 7

What are the Political Parties Preferences?

Answer 7

The model envisages two political parties: party D (Democratic - left wing), and party R (Republican- right wing).

Party D, relative to party R:

• is more concerned with growth and unemployment
• therefore less concerned with inflation

Although each party faces an inflation-growth trade-off, their preferences differ.

Different political preferences are captured by each party having different objective functions.

• In the Barro-Gordon model, we were concerned with a single objective function (this took the form of a quadratic loss function, the value of which we wished to minimise); in this example, we have two objective functions - one for each political party - the values of which we instead wish to maximize.

Question 8

What are the the Left Wing Parties Preferences?

Answer 8

• deviations from target inflation and falling output lowers utility
• b_D shows how much the democratic party cares about output relative to inflation

Question 9

What are the the Right Wing Parties Preferences?

Answer 9

• similar to the democratics preferences but their will be difference in their target rates of inflation and the extent to which their care about output relative to inflation

Question 10

What is the intuition behind the differing inflation targets for the two political parties?

Answer 10

• they are inflation adverse as inflation erodes savings and the value of their investments

Question 11

What is the intuition behind the differing values of b for the two political parties?

Answer 11

Question 12

What are Voter i’s preferences?

Answer 12

Question 13

If the Democrats were elected into power what policy would they set?

Answer 13

• equation 16 can be derived from substitution of π and differentiating with respect to it
• expected inflation = the real inflation rate
• actual rate of output = natural rate of output - y(bar)

This outcome arise when if only the democratic party existed and their was no competition from the Republicans

Question 14

how does timing affect our model with respect to the election process?

Answer 14

1. Wage contracts signed for period 1
2. Elections for period 1
3. Winning political party chooses π for period 1 4 Growth occurs in period 1
4. Contracts signed for period 2
5. Period 1 election winner chooses π for period 2 (no new elections).
6. Growth occurs in period 2

Once a party is voted in, they are voted in for 2 periods

Question 15

How does Probability and Uncertainty affect target inflation if the Democratic party wins?

Answer 15

Question 16

How does Probability and Uncertainty affect target inflation in the Republican party is voted in?

Answer 16

Question 17

What is expected inflation in the second period?

Answer 17

Question 18

What does the cycle of output growth on a graph?

Answer 18

• below average growth in the period republican is voted in and above natural rate growth when the democratic party is voted
• in the second period, as their is no uncertainty, output is at its natural rate.

Question 19

What does the cycle of inflation look like on a graph?

Answer 19

• inflation oscillates depending who is elected

Question 20

What conclusions can we draw from the flucuation in the two cycles?

Answer 20

Question 21

How do Politicians influence their ‘independent central banks’ through legislative threats?

Answer 21

Havrilesky (1995)

• U.S., presidential influence over monetary policy derives in part from the Fed’s need to deflect Congressional threats to its independence
• accommodates presidental wishes so that they aren’t treated with legislative intrusion
• The Congress implicitly gains from this standoff as well: it can publicly “bash” the Fed for its bad performance while escaping direct responsibility for economic outcomes

Question 22

How do Politicians influence their ‘independent central banks’ through appointing economists?

Answer 22

• Keech and Morris (1997)
  
  • have noted that if influence over policy comes primarily through the power of appointment, policy shifts associated with regime changes in the executive branch may be gradual and delayed; it takes time for a president to “pack the Board” with loyal supporters.
    *

Question 23

How do Politicians influence their ‘independent’ central banks with appointment?

Chappell, Havrilesky, and McGregor (1993)

Answer 23

Chappell, Havrilesky, and McGregor (1993)

have used dissent voting data to infer that U.S. presidents’ partisan influences over monetary policy come primarily via the power appointment rather than direct pressure.

This poses a particular challenge for rational partisan models described earlier: rational partisan models require that elections produce policy surprises, but election-related surprises will be minimal if policy change must await a packed Board.

Question 24

What are the political origin of inflation?

Answer 24

Barro and Gordon (1983)

• If the public expected zero inflation, policymakers would have an incentive to increase output with a positive money supply surprise.
• Cukierman (1992)
• has shown that the revenue motive can produce an inflation rate exceeding the steady-state seigniorage-maximizing rate.
• He also provides some empirical support for the seigniorage motive from cross country evidence – seigniorage is a more important source of revenue when tax institutions are less efficient and political systems less stable

Question 25

(Schultz, 1995)

Answer 25

• The more likely the government is to be re-elected, the less it can gain by inducing cycles that are costly because of their impact on both the government’s reputation and future macroeconomic performance.
• The degree to which the government manipulates the economy should thus be negatively correlated with its political security prior to an election