Unemployment and Political Business Cycle

Unemployment and Political Business Cycle This paper demonstrates relationships between political business cycles (PBCS) and unemployment as referred to by the article titled, “The political Business Cycle after 25 Years” by Allen Drazen. Consider the situation where the political party in power maximizes a quadratic vote function whose arguments are the rates of unemployment and of inflation. Each of the set of indifference or iso-vote curves labeled V 1 shows the different combinations of inflation, p, and unemployment, u, which will yield some particular percentage of the votes cast for the incumbent at the next election. The lower are p and u, the larger is the vote share of the party in power in the coming election. Thus points on indifference curves (iso-vote lines) closer to the origin are preferred to ones further away. The party in power is assumed able to set unemployment at any desired rate, but it is constrained by a short-run Phillips curve which shifts over time. Thus it may lower the unemployment rate in the short run but it pays a double price in terms of higher inflation now and a worse short-run inflation-unemployment trade-off in the next period.

In the figures, LR represents the long-run Phillips curve (drawn with a slight negative slope to illustrate that the analysis does not require a vertical long-run curve). The SR 1 and SR 2 curves represent two different families of short-run inflation-unemployment trade-offs, with the SR 1 curves having a steeper slope than the SR 2 curves. Attempts to exploit short-run points to the left of the longrun curve will shift out the short-run curve over time, while the adoption of points to the right of the long-run curve would shift the short-run curve in. Long-term equilibrium occurs where the long-run and short-run curves intersect on an indifference curve, at points e1 and e2 respectively in the figures. Let the initial inflation-unemployment values be those given by point A in each figure. In both of these cases the party in power is able to increase its vote share in the next election by moving along the relevant short-run trade-off to point B, which is tangent to a more southwest dashed indifference or iso-vote curve.

In each case there are incentives to inflate prior to the election. Note, however, that the flatter the short-run trade-off curves, the greater the long-run inflation rate (e2 is higher than e1). The effects of the slopes of the short-run curves on the political equi- librium rate of inflation have not been emphasized in the early treatments of the political business cycle. The greater the short-run flexibility of wages and prices and the less sluggish the adjustment of expectations, the steeper will be SR and hence, the less will be the incentives for overexpansion. This implies that rather than being the engine of inflation that many have charged, flexible exchange rates may help reduce inflationary tendencies. This is because the rapid adjustment of exchange rates tends to speed up the price effects of changes in macroeconomic policy and, hence, steepen SR. Another aspect that relates to PBCS is the term myopia that has been defined differently by many economists in discussing PBCS, and these differences have created confusion in critiquing the literature.

Both the government and voter may suffer from myopia. Governmental myopia implies that incumbents attach zero value to macroeconomic outcomes past the election date. Thus many describe a purely myopic policy where planners apply infinite discount rates in evaluating policy. This would not preclude perfect foresight of incumbents: models of incumbent myopia are consistent with the work of Barro and Gordon and of Backus and Driffill, which emphasizes a democratic government's inability to be bound by contract to socially optimal policies even when it desires to do so. The PBC literature of this variety presumes that incumbents instead are vote maximizers. Government myopia is common to most but not all PBC models. The most notable exception is the work by Frey in which ideological goals (whose benefits for the incumbent fall partly in future periods) are pursued given reasonable assurance of re-election.

Returning to our initial discussion, given the diversity of preferences of the public, we would say public choice analysis finds that the Nordhaus model contains a perfect competitive check on independent political behavior which forces government behavior to conform to median voter preferences, thus avoiding an inflationary bias according to one standard norm (i.e., a non-median voter outcome). But this is not the median voter outcome that would occur if all voters were fully informed of the long-run effects of expansionary policies. This outcome would occur at the point of tangency of the long-run Phillips curve to the lowest iso-vote contour possible. The inflationary bias away from this point is greater, the less informed and the more myopic the general public.