Political Business Cycles in the New Keynesian Model

Fabio Milani ()

No 70805, Working Papers from University of California-Irvine, Department of Economics

Abstract: This paper tests various Political Business Cycle theories in a New Keynesian model with a monetary and fiscal policy mix. All the policy coefficients, the target levels of inflation and the budget deficit, the firms' frequency of price setting, and the standard deviations of the structural shocks are allowed to depend on 'political' regimes: a pre-election vs. post-election regime, a regime that depends on whether the President (or the Fed Chairman) is a Democrat or a Republican, and a regime under which the President and the Fed Chairman share party affiliation in pre-election quarters or not. The model is estimated using full-information Bayesian methods. The assumption of rational expectations is relaxed: economic agents can learn about the effect of political variables over time. The results provide evidence that several coefficients depend on political variables. The best-fitting specification is one that allows coefficients to depend on a pre-election vs. non-election regime. Monetary policy becomes considerably more inertial before elections and fiscal policy deviations from a simple rule are more common. The results overall support the view of an independent Fed that avoids taking policy decisions right before elections. There is some evidence, however, that policies become more expansionary before elections, but this evidence seems to disappear in the post-1985 sample. The estimates also indicate that firms similarly delay their price-setting decisions until after the upcoming Presidential election.

Keywords: Political business cycles; Opportunistic cycles; Partisan cycles; Monetary and fiscal policy; Adaptive learning; Bayesian estimation (search for similar items in EconPapers)
JEL-codes: C11 D72 E32 E52 E58 E63 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-pol
Date: 2007-11
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Persistent link: http://EconPapers.repec.org/RePEc:irv:wpaper:070805

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