"On the 'Faustian' Dynamics of Policy and Political Power"

This paper examines the Faustian dynamics of policy and power. We posit a general class of dynamic games in which current policies affect the future distribution of political power, resulting in the following “Faustian trade off”: if the current ruler chooses his preferred policy, he then sacrifices future political power; yet if he wants to preserve his future power, he must sacrifice his present policy objectives. The trade-off comes from the fact that the current political ruler/pivotal voter cannot un-couple the direct effect of his policy from its indirect effect on future power. A Policy-endogenous (PE) equilibrium describes this endogenous transfer of power, and the resulting evolution of policy and political power over time. We show that the Faustian trade-off in a PE equilibrium is decomposed into two basic rationales. The political preservation effect induces more tempered policy choices than if one’s policy choice did not affect one’s political fortunes. However, the reformation effect induces “more aggressive” policies in order to exploit the productivity gains from policies chosen by even more aggressive successors. We distinguish between political systems that give rise to monotone Faustian dynamics — political power that progressively evolves toward more fiscally liberal types of leaders, and cyclical Faustian dynamics — political power that oscillates between liberal and conservative types of leaders. In each case, we show that the Faustian trade off moderates the choices of each type of leader.Monotone and cyclical Faustian dynamics, policy-endogenous equilibrium, permanent authority, preservation and reformation effects, biased political system, distortion-adjusted Euler equation

Monetary Equilibria in a Cash-in-Advance Economy with Incomplete Financial Markets

The general equilibrium model with incomplete financial markets (GEI) is extended by adding fiat money, fiscal and monetary policy and a cash-in-advance constraint. The central bank either pegs the interest rate or money supply while the fiscal authority sets a Ricardian or a non-Ricardian fiscal plan. We prove the existence of equilibria in all four scenarios. In Ricardian economies, the conditions required for existence are not more restrictive than in standard GEI. In non-Ricardian economies, the sufficient conditions for existence are more demanding. In the Ricardian economy, neither the price level nor the equivalent martingale measure are determinate.Money, Incomplete Markets, Fiscal Policy, Indeterminacy

Monetary Equilibria in a Cash-in-Advance Economy with Incomplete Financial Markets

The general equilibrium model with incomplete financial markets (GEI) is extended by adding fiat money, fiscal and monetary policy and a cash-in-advance constraint. The central bank either pegs the interest rate or money supply while the fiscal authority sets a Ricardian or a non-Ricardian fiscal plan. We prove the existence of equilibria in all four scenarios. In Ricardian economies, the conditions required for existence are not more restrictive than in standard GEI. In non-Ricardian economies, the sufficient conditions for existence are more demanding. In the Ricardian economy, neither the price level nor the equivalent martingale measure are determinate.Money, incomplete markets, fiscal policy, indeterminacy

Revealed Political Power

This paper adopts a \revealed preference" approach to the question of what can be inferred about bias in a political system. We model an economy and its political system from the point of view of an \outside observer." The observer sees a nite sequence of policy data, but does not observe either the citizens' preference prole or underlying distribution of political power that produced the policies. The observer makes inferences about distribution of political power as if political power were derived from a wealth-weighted voting system with weights that can vary with the state of the economy. The weights determine the nature and magnitude of the wealth bias. Positive weights on relative income in any period indicate an \elitist" bias in the political system whereas negative weights indicate a \populist" one. As a benchmark, any policy data is shown to be rationalized by any system of wealthweighted voting. However, by augmenting the observer's observations with polling data, nontrivial inference is possible. We show that joint restrictions resulting from the policy and polling data together imply upper and lower bounds on the set of rationalizing biases. These bounds can be explicitly calculated and can be used to discern instances of elitist bias; in other times they show populist bias. Additional restrictions on the preference domain can rule out the unbiased benchmark case of equal representation.wealth-bias, elitist bias, populist bias, weighted majority winner, rationalizing weights, "Anything Goes Theorem"

Government Purchases Over the Business Cycle: the Role of Economic and Political Inequality

This paper explores the implications of economic and political inequality for the business cycle comovement of government purchases. We set up and compute a heterogeneous-agent neoclassical growth model, where households value government purchases which are financed by income taxes. A key feature of the model is a wealth bias in the political aggregation process. When calibrated to U.S. wealth inequality and exposed to aggregate productivity shocks, such a model is able to generate milder procyclicality of government purchases than models with no political wealth bias. The degree of wealth bias that matches the observed mild procyclicality of government purchases in the data, is consistent with cross-sectional data on political participation.

Public Consumption Over the Business Cycle

What fraction of the business cycle volatility of government purchases is accounted for as endogenous reactions to overall macroeconomic conditions? We answer this question in the framework of a neoclassical representative household model where the provision of a public consumption good is decided upon endogenously and in a time-consistent fashion. A simple frictionless version of such a model with aggregate productivity as the sole driving force can explain almost all the volatility of U.S. non-defense government consumption expenditures. However, such a model fails to match other important features of the business cycle dynamics of public consumption, which comes out as not persistent enough and too synchronized with the cycle. We add implementation lags and implementation costs in the budgeting process to the model, plus taste shocks for public consumption relative to private consumption, and achieve a substantially better match to the data. All these ingredients are essential to improve the fit. Depending on the precise specification of the flow utility function over private consumption, public consumption and leisure, 25-40 percent of the variance of public consumption is driven by aggregate productivity shocks.