POLITICAL BUSINESS CYCLES IN THE NEW KEYNESIAN MODEL

"I know there's the myth of the autonomous Fed ..." Nixon barked a quick laugh. --Richard Nixon, talking to Arthur Burns on October 23, 1969, just after Burns's nomination to the Fed had been announced. (1) "I'd like to see another lowering of interest rates. I think there's room to do that. I can understand people worrying about inflation. But I don't think that's the big problem now." --George H. W. Bush, interview with New York Times, June 24, 1992. I. INTRODUCTION Economic conditions before elections affect election outcomes. (2) Rational politicians who recognize this regularity may, therefore, be tempted to try to influence the economy in the quarters preceding an election date to maximize their chances of being reelected. The literature on political business cycles (PBC) has developed models that rationalize economic fluctuations induced by political cycles. Nordhaus (1975) presented a model of "opportunistic" political cycles: the party in power stimulates the economy before elections to improve its reelection probability. Others have observed that different parties may have different preferences over inflation and output or unemployment outcomes and, therefore, we should observe "partisan" political cycles. Hibbs (1977) was the first to introduce the partisan cycle model, in which left-wing parties were assumed to have at least one of the following: a higher output target, a higher inflation target, or a higher relative weight on minimizing output rather than inflation deviations from the targets, compared with right-wing parties. Several papers test for the existence of opportunistic or partisan cycles in the United States. Alesina, Cohen, and Roubini (1992) and Alesina, Roubini, and Cohen (1997) find only weak evidence of an opportunistic political cycle looking at M1 growth rates. Grier (1989) and Beck (1987), instead, find support for the effect of political variables on M1 growth rates for the 1960-1980 period, but not on the mean level of the federal funds rate. As discussed in Drazen (2000a, 2000b), there is basically no evidence, instead, that political cycles matter for macroeconomic outcomes by looking at data on unemployment and output growth (Grier 2008 is a recent exception), and only weak evidence for inflation. Empirical tests of the partisan cycle model (Alesina, Roubini, and Cohen 1997; Faust and Irons 1999) find partisan differences in output growth rates, but no support for partisan cycles in inflation and monetary policy. Tests of PBC typically assume monetary policy as the main tool that is exploited by politicians to manipulate the economy. These studies usually focus on comparing the level of inflation, output, money growth rates, or interest rates across political cycles, or they add a political dummy variable to the relevant regression and test its significance. This paper offers a different approach. The paper aims to empirically test various political business cycle theories adopting an optimizing New Keynesian model with a monetary and fiscal policy mix as the main setting (the inclusion of both fiscal and monetary policy is motivated by Drazen 2000b). (3) The New Keynesian model is a baseline setting for the analysis of monetary policy, but it has not been widely used to study PBC. An advantage of this paper with respect to most of the previous PBC literature lies in the use of a general equilibrium framework: this is, in fact, necessary when testing the importance of politically motivated policy choices to effectively control for differences in the macroeconomic conditions, the set of shocks, or the private sector expectations that prevail when the policy decision is taken. The monetary and fiscal policy rule parameters, as well as the parameters that reflect the frequency of price adjustment by firms and the steady-state level of inflation, are allowed to depend on the (observed) political regime. …