WEEK 2 - Partisan Business Cycles Flashcards
What is Hibbs’ suggestion about political parties and economics?
- That partisan influence on real econ activity shown to have permanent effects
- Left wing parties prefer combos of output and unemployment which differ from right wing choices
What is combo of output and unemployment that left wing parties typically have?
Assumed to be more willing to bear the costs of inflation in order to lower unemployment (also in turn increasing econ growth)
What is one of the initial criticisms to Hibbs’ suggestion?
Developments in econ theory past the 60’s suggest this trade off not easily exploitable (unemployment and inflation)
What do Alesina and Rosenthal develop?
A similar model to Hibbs within rational expectations framework
Known as the rational partisan theory
At odds with Nordhaus’s traditional business cycle models
What does Nordhaus’s model imply?
predicts that economic growth should be lower before
an administration comes to power, irrespective of its political ideology
In the rational partisan theory when does the business cycle occur?
Due to the uncertainty generated by competitive partisan politics
What do we initially assume about the rational partisan theory?
-Structure of economy given by y = γ (πt - wt)+ Y bar
-Nominal growth in wages (wt) equal to expected inflation rate (πe):
wt = πe
Where:
- yt: Growth rate of GDP
- πt: Rate of inflation
- wt: Growth rate of nominal wages
- y bar: Natural rate of econ growth
- γ >0 is a parameter
- t is a time subscript
How can we rewrite the structure of the economy knowing that nominal growth in wages is equal to expected inflation rate?
y = γ (πt - πe )+ Y bar
What are the political party preferences in the model?
Party D (democratic) and Party R (Republican)
Party D more concerned with growth and unemployment less so with inflation
What is the formal representation of Party D’s preferences? (The Objective Function)
uD = - (πt - πD bar)2+ bDyt
Such that πD bar>0 and bD>0
Where:
πD bar = Target inflation rate associated with D
bD = Represents extent to which D cares about output
How do we rewrite D’s preferences with the structure of the economy considered?
uD = - (πt - πD bar)2 + bDγ(πt - πe) + bDy bar
What is implied by D’s preferences with the structure of the economy considered?
Implies that policymaker benefits from unexpected burst of inflation (if πt > πe,uD rises)
What is the formal representation of Party R’s preferences? (The Objective Function)
uR = - (πt - πR bar)2 + bRyt
Such that πR bar >0 and bR>0
Where:
πR bar = Target inflation rate associated with D
bR = Represents extent to which R cares about output
How do we rewrite R’s preferences with the structure of the economy considered?
uR = - (πt - πR bar)2 + bRγ(πt - πe) + bRy bar
What is implied by R’s preferences with the structure of the economy considered?
R benefits from an unexpected burst of inflation (e.g. if πt > πe,uR rises)
What are some conditions assumed about both party preference’s?
πD bar> πR bar> 0
bD > bR > 0
What is implied by the assumption of πD bar> πR bar> 0
Implies that the democratic party has a higher tolerance of inflation than republicans.
They target a higher lvl of inflation.
As blue collar workers less risk averse to inflation compared to the rich (typically rich republicans)
What is implied by the assumption of bD > bR > 0
Implies that the democrats care more for output growth relative to inflation (i.e for any y, the effect transmitted to democratic utility in uD greater than Republican utility uR)
What is the formal representation of the generic voter i’s policy preferences?
ui = - (πt - πi bar)2 + biyt
Such that:
πi bar > 0
bi> 0
How do we rewrite voter i’s preferences with the structure of the economy considered?
ui = - (πt - πi bar)2 + biγ(πt - πe) + biy bar
What is implied by voter i’s preferences with the structure of the economy considered?
Voter i benefits from an unexpected burst of inflation
What does knowing voter i’s preferences help to determine?
Helps to determine the probability he or she will vote for a given political party
What do we assume Party D will set policy wise?
- Wages (w) set to equal expected inflation (πe) at start of period t
- Party D chooses inflation (π) after inflation expectations formed
- Policymaker (Party D) thus takes expectations as given when choosing π as expectations already given
What is the formal representation of what we assume Party D to set policy wise? (Optimal Policy)
πt = πD* = πd bar + bdγ /2
πet = πD* = πD bar + bdγ /2
yt = Y bar
Roughly the same for Party R’s optimal policy
What do we then assume in regards to optimal policy?
πD> πR
What are some of the effects of timings in regards to elections?
- Wage contracts signed for period 1
- Elections for period 2
- Winning political party chooses π for period 1
- Growth occurs in period 1
- Contracts signed for period 2
- Period 1 election winner chooses π for period 2 (no new elections)
- Growth occurs in period 2
How can we see how D would choose inflation in period t=1? (Considering uncertainty of election results)
-Assuming party D wins elections with probability P and R wins with (1-P)
In 1st period have:
πe1 = PπD* + (1-P)πR*
If D wins, then period t=1 output (using structure of economy) equals:
yD1 = γ(π1 - πe1) + Y bar
= γ(π1 - (PπD* + (1-P)πR*))+ Y bar
What does the probability of Party D winning and choosing inflation in period 1 reduce to and show?
Prior equation (Flashcard 27) reduces to: yD1 = y bar + γ(1-P)(πD*-πR*)
Shows that if D wins inflation chosen by Democratic Party in t=1 such that πt = π1 = πD*
How can we see how R would choose inflation in period t=1? (Considering uncertainty of election results)
-Assumption that party D wins election with probability P and Party R wins with probability (1-P)
In 1st period:
πe1 = PπD* + (1-P)πR*
If R wins, then period t=1 output (using structure of economy equals)=
Yr1 = γ(π1 - πe1) +Y bar
= γ(πr* - (PπD* +(1-P)πR))+ Ybar
= γ(- PπD + PπR*)+ Y bar
What does the probability of Party R winning and choosing inflation in period 1 reduce to and show?
Prior Equation (from slide 29) Reduces to: Yr1 = Ybar - γP(πD* - πR*)
Shows if R wins, inflation be chosen by Republic party in period t=1, such that πt = π1 = πR*
What are the expectation of Party D or Party R winning in the second period?
πe2 = πD* if D in office πe2 = πR* if R in office yt = y bar with either D or R in office
What are the elements of 2nd period expecations?
- Driver of electoral cycle is first period expectations forces public to take account of both possible outcomes when forming first period expectations
- In second period, no electoral uncertainty, as voters know who’s in power and form expectations accordingly
Generates output growth and inflation cycles
What are some observations on the nature of fluctuations?
Part 1
- Greater political polarisation causes greater econ fluctuations
- the greater the differences in πD bar and
πRbar , and the greater the difference between bD and bR , the greater
are deviations of output growth from y bar - Degree of surprise of policy outcome also affects amplitude of output fluctuations
(as p increase (likelihood of D victory)
What are some observations on the nature of fluctuations?
Part 2
Degree of surprise of policy outcome also affects amplitude of output fluctuations
(as p increase (likelihood of D victory), greater the recession generated by R victory because the less expected is the inflation shock
Why does an R party victory causes growth downturns or recessions?
Due to expectation being kept high of D victory. So, t=1 downturn to eradicate inflationary expectations fro public
How do we identify if a voter will vote for the republicans or democrats?
Voter i will vote for the Republican party if his lifetime utility under a
Republican president uiR
higher than under Democratic president uiD
How do we identify total utility for each voter?
Sum of utilities over each period:
0
How do we formally represent voter i’s utility with parties R and D?
uiR = - (πRbar* - πi bar)2 + biy1R + β[- (πRbar* - πi bar)2 + biY bar]
uiD = - (πDbar* - πi bar)2 + biyiD + β[- (πDbar* - πi bar)2 + biY bar]
When can we assume a republican party will win?
If uiR > uiD for over 50% of the electorate
- expect voters with relatively higher
values for πi and bi to vote for the Democratic party (vice versa for Republicans)
