7 - Partisan business cycles

Summary

INTRODUCTION

One of the most important public policy issues is the definition of an economic policy that controls the level of inflation, GNP growth, and unemployment by means of monetary and fiscal stimuli. In order to analyze the effects of partisan politics on the economic cycle, one needs a view of how the economy works, a model linking economic policies to economic outcomes. Our economic model, although very simple, blends two important elements that are widely emphasized in modern macroeconomic theory: the “rational expections” and the “wage–price rigidity” hypotheses.

The mechanism of expectation formation and the extent of price and wage flexibility have been at the core of the macroeconomic debate in the last thirty years. In the fifties and sixties, mainstream Keynesians held that policymakers could easily control real macroeconomic variables, such as GNP growth and unemployment. The crucial relationship in this Keynesian approach is the “Phillips curve”, which relates inflation to unemployment (or GNP growth). A relatively stable inverse relationship between inflation and unemployment was thought to be exploitable for policy purposes: by means of appropriate combinations of monetary and fiscal policies, the policymakers were supposed to be able to choose a point along this macroeconomic trade-off; for instance, by expanding aggregate demand and accepting the costs of some inflation, policymakers could expand economic activity, at least up to a point. Thus, the effects of macroeconomic policies, both fiscal and monetary, were thought to be predictable and stable.