WEEK 2 - Partisan Business Cycles

Question 1

What is Hibbs’ suggestion about political parties and economics?

Answer 1

• 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

Question 2

What is combo of output and unemployment that left wing parties typically have?

Answer 2

Assumed to be more willing to bear the costs of inflation in order to lower unemployment (also in turn increasing econ growth)

Question 3

What is one of the initial criticisms to Hibbs’ suggestion?

Answer 3

Developments in econ theory past the 60’s suggest this trade off not easily exploitable (unemployment and inflation)

Question 4

What do Alesina and Rosenthal develop?

Answer 4

A similar model to Hibbs within rational expectations framework

Known as the rational partisan theory

At odds with Nordhaus’s traditional business cycle models

Question 5

What does Nordhaus’s model imply?

Answer 5

predicts that economic growth should be lower before

an administration comes to power, irrespective of its political ideology

Question 6

In the rational partisan theory when does the business cycle occur?

Answer 6

Due to the uncertainty generated by competitive partisan politics

Question 7

What do we initially assume about the rational partisan theory?

Answer 7

-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

Question 8

How can we rewrite the structure of the economy knowing that nominal growth in wages is equal to expected inflation rate?

Answer 8

y = γ (πt - πe )+ Y bar

Question 9

What are the political party preferences in the model?

Answer 9

Party D (democratic) and Party R (Republican)

Party D more concerned with growth and unemployment less so with inflation

Question 10

What is the formal representation of Party D’s preferences? (The Objective Function)

Answer 10

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

Question 11

How do we rewrite D’s preferences with the structure of the economy considered?

Answer 11

uD = - (πt - πD bar)2 + bDγ(πt - πe) + bDy bar

Question 12

What is implied by D’s preferences with the structure of the economy considered?

Answer 12

Implies that policymaker benefits from unexpected burst of inflation (if πt > πe,uD rises)

Question 13

What is the formal representation of Party R’s preferences? (The Objective Function)

Answer 13

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

Question 14

How do we rewrite R’s preferences with the structure of the economy considered?

Answer 14

uR = - (πt - πR bar)2 + bRγ(πt - πe) + bRy bar

Question 15

What is implied by R’s preferences with the structure of the economy considered?

Answer 15

R benefits from an unexpected burst of inflation (e.g. if πt > πe,uR rises)

Question 16

What are some conditions assumed about both party preference’s?

Answer 16

πD bar> πR bar> 0

bD > bR > 0

Question 17

What is implied by the assumption of πD bar> πR bar> 0

Answer 17

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)

Question 18

What is implied by the assumption of bD > bR > 0

Answer 18

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)

Question 19

What is the formal representation of the generic voter i’s policy preferences?

Answer 19

ui = - (πt - πi bar)2 + biyt

Such that:
πi bar > 0
bi> 0

Question 20

How do we rewrite voter i’s preferences with the structure of the economy considered?

Answer 20

ui = - (πt - πi bar)2 + biγ(πt - πe) + biy bar

Question 21

What is implied by voter i’s preferences with the structure of the economy considered?

Answer 21

Voter i benefits from an unexpected burst of inflation

Question 22

What does knowing voter i’s preferences help to determine?

Answer 22

Helps to determine the probability he or she will vote for a given political party

Question 23

What do we assume Party D will set policy wise?

Answer 23

• 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

Question 24

What is the formal representation of what we assume Party D to set policy wise? (Optimal Policy)

Answer 24

πt = πD* = πd bar + bdγ /2

πet = πD* = πD bar + bdγ /2

yt = Y bar

Roughly the same for Party R’s optimal policy

Question 25

What do we then assume in regards to optimal policy?

Answer 25

πD> πR

Question 26

What are some of the effects of timings in regards to elections?

Answer 26

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

Question 27

How can we see how D would choose inflation in period t=1? (Considering uncertainty of election results)

Answer 27

-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

Question 28

What does the probability of Party D winning and choosing inflation in period 1 reduce to and show?

Answer 28

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*

Question 29

How can we see how R would choose inflation in period t=1? (Considering uncertainty of election results)

Answer 29

-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

Question 30

What does the probability of Party R winning and choosing inflation in period 1 reduce to and show?

Answer 30

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*

Question 31

What are the expectation of Party D or Party R winning in the second period?

Answer 31

πe2  = πD* if D in office
πe2 = πR* if R in office 
yt = y bar with either D or R in office

Question 32

What are the elements of 2nd period expecations?

Answer 32

• 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

Question 33

What are some observations on the nature of fluctuations?

Part 1

Answer 33

• 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)

Question 34

What are some observations on the nature of fluctuations?

Part 2

Answer 34

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

Question 35

Why does an R party victory causes growth downturns or recessions?

Answer 35

Due to expectation being kept high of D victory. So, t=1 downturn to eradicate inflationary expectations fro public

Question 36

How do we identify if a voter will vote for the republicans or democrats?

Answer 36

Voter i will vote for the Republican party if his lifetime utility under a
Republican president uiR
higher than under Democratic president uiD

Question 37

How do we identify total utility for each voter?

Answer 37

Sum of utilities over each period:

0

Question 38

How do we formally represent voter i’s utility with parties R and D?

Answer 38

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]

Question 39

When can we assume a republican party will win?

Answer 39

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)