Bankovní institu vysoká škola Praha Katedra finančnictví a ekonomických disciplin Politický a hospodářský cyklus v teorii a praxi Diplomová práce Autor Abbas Tursunmetov

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1.5.3.The real business cycle theory

On the basis of supply shocks a group of classical economists headed by Edward Prescott and Finn developed real business cycle theory (RBC). In accordance with this theory the major source of business cycles in the economy are the real shocks14

Real shocks are real economic disturbances, which effect only real variables (not nominal) such as the production function or consumer decisions. The economists contrast real shocks to nominal such as shocks to demand and supply of money. Speaking in terms of the IS-LM model, real shocks directly affect the IS and FE curves, whereas nominal shocks only affect the LM curve.

Although various real shocks explain business cycles, the adherents of the RBC theory emphasize the role of supply or productivity shocks. In accordance to their view, most of booms and recessions are the products of positive or favorable supply shocks since the latter increase the output volume for given levels of capital and labor. At the same time recessions are the cases of negative or unfavorable supply shocks.

In the Bernanke’s “Macroeconomics 5th” question to RBC supporting economists –about existence of economic effects of positive or negative productivity shocks was presented and analyzed on example of raising oil prices15 reduces marginal product of Labor (MPN) and the demand for labor in any real wages.

This results in a reduction of equilibrium real wages and employment. Equilibrium output falls as a result of equilibrium employment reduction. This case illustrates that negative productivity shock reduces output levels that can be produced at any amount of capital and labor.

There were also examples of using the IS-LM model to study the impact of negative productivity shocks on the state of equilibrium. The results of these study showed that negative productivity shocks led to the reduction in the equilibrium levels of employment, real wages, real output, investment, and consumption with accompanying increases in the level of prices and the interest rate.

Note that in accordance with the RBC theory the output falls during recessions and increases during booms due to the changes in equilibrium level of output (full-employment level). At the same time, the flexibility does not insure the equality of actual output to full-employment level of output.

The RBC theory and facts. The RBC theory which combines the classical version of the IS-LM model with the assumption that shocks are the main type of disturbance in economic development is consistent with much of the business cycles.

• The RBC theory correctly predicts that changes in employment are pro-cyclical meaning that changes in employment and output are positively related.

• In accordance with the RBC theory, real wages tend to be higher during booms and lower during recessions (procyclical movement of real wages) which is also consistent with reality

• At the same time, the RBC theory shows that average labor productivity is higher during booms and lower during recessions (procylclical behavior).

Proponents of the RBC theory, by showing that without productivity shocks the increments of employment will lead to the reduction of average labor productivity due to the diminishing marginal returns, consider procylclical behavior of labor productivity as a main argument justifying their approach.

However, the tendency of inflation to slow down during recessions and accelerate during expansions seems to be inconsistent with a simple version of the RBC theory. The RBC theory predicts that negative productivity shocks cause simultaneous increase in the level of prices and decrease in the output levels. Therefore, the RBC theory considers recessions as periods of increasing inflation. However, the last consideration seems to be inconsistent with the actual data.

Kydland and Prescott16showed that conclusions with respect to the behavior of inflation tend to depend on the empirical approaches used to estimate inflation and output trends. Using different approach, Kydland and Prescott found that at times when aggregate output was below its long-term level, inflation fell below its long-term levels confirming the idea of cyclical behavior of price of the RBC theory.

Kydland and Prescott suggested that conventional view of price and inflation pro-cyclicality was mainly based on the experiences of the economy during the two world wars (1918-1941); that is, at times when the economy had different structure and exposed to other types of shocks. Nevertheless, the problem of the cyclic behavior of prices remains controversial.

2. The main theories and models of political cycle

Political economy has received much attention in recent years in the United States, Britain, and Scandinavian countries. It is recognized by political scientists who seek to apply economic models for the study of political reality. In this respect, Schumpeter’s book "Capitalism, Socialism and Democracy" (1942), where he first provides economic interpretation of democracy by using competitive leadership theory was widely recognized. Modern western political economy is represented by Downs’ political cycles, Arrow’s "public option" theory, Becker’s economic analysis of political behavior and a number of other studies. One of the most prominent and famous researchers in this field are Nordhaus, Taft, Hibbs, Mosley and Alesina.

  • All models of political cycles are based on the following set of assumptions:

  • Governments tend to maximize the number of votes to win elections;

  • Each voter has preferences of economic performance, which is reflected in his/her voting behavior;

  • Governments can manipulate the economy to improve their chances of re-election.

Many economists associate frequent fluctuations in monetary policy with changing goals of various political regimes. These economists assert that policymakers tend to affect economic activity to earn political popularity and be re-elected. Under these conditions an important determinant of short-term dynamics is policymaker’s position duration or so called election cycle. The hypothesis that cycles of economic activity are determined by the election outcomes is called political business cycle theory.

Nordhaus was the first who presented empirical representation of these views using game-theoretic approach in 197517. However, it was criticized for being based on irrational behavior and lack of foresight of the voters. Further developments resulted in wider use of game theory approach along with weakening of unrealistic assumptions of the model by accounting for rational expectations and differences in the political platforms of competing parties. This chapter discusses the assumptions and conclusions of the two most prominent models, namely, Nordhaus18 modeland political cycles model in the two-party system of Alesina19.

2.1 Hibb’s model of political business cycle

Cyclical nature of the business activity is explained by changes in the ruling parties. Changes in the ruling parties with different objectives and different policies initiate cycles in the economy. In such cases, economic conditions change after the election process and last at least one electoral period.

Hibb’s model20 of political business cycle is built on the assumption that each county faces a trade-off between inflation and unemployment described by the Phillips curve. Left-wing parties put more emphasis on employment policies direct to unemployment reduction. Hence, governments with ruling left-wing parties are usually characterized by low levels of unemployment (or high levels of employment) and high levels of inflation in contrast to the government with right-wing or centrist ruling parties. This is explained by the working class’s preferences for low unemployment.

Hibbs non-rational framework has similar critiques as those made to Nordhaus’ model: non-rationality incorporates backward-looking voting behavior and adaptive inflation expectations. The implications of both assumptions were discussed in section two. Secondly, Hibbs model does not identifies whether parties use monetary or fiscal instruments to hit their targets although a monetary instrument is more likely given that he analyses unemployment-inflation trade-offs

2.2 Buchanan’s social choice theory

The study of collective decision-making became an important milestone in the development of political economy. Analysis of non-market processes to identify and agree on the preferences through political institutions is a matter of social choice theory. This theory finds its origins from the works of Nobel Prize winner James Buchanan, who applied neoclassical economic theory to study political processes21. Such economists as Tulloch, Olson, Muller, Tollison, Neskanen, and Hayek made substantial contributions to the development of this theory. Social choice theory is the basis for modern public economics.

At the heart of the social choice theory is the concept of individual collective organization. Collective actions are seen as a result of collective and not individual decision making to achieve certain goal. Individual behavior in the political sphere (as voters is the result of individual economic roles (buyers and sellers, businesses and workers). Buchanan’s purpose of the analysis was to study not the concepts of "nation", "state", "party", but the ability of these individuals to make a variety of decisions leading to the overall economic benefit and at the same time influencing the political complexion of the whole society, including the face of a "nation "," state ", etc.

According to Buchanan, the individual maximizes the utility from market and political exchange (where political activity is seen as a specific for of exchange, where political market is analogous to goods market). Individuals in the economy and politics pursue similar goals as utility maximization. The state plays the role of competitive market where individuals compete for the influence on the decision-making, access to resource allocation and the place in hierarchy. However, the state is a special type of the market. Its participants have certain rights and obligations, specifically voters can choose the representatives in the government, delegates issue and adopt laws, whereas the officials control law abidingness. Voters and politicians are treated as individuals exchanging votes and campaign promises22.

However, policymakers are guided by their personal interest which may not always coincide with the social interests. The major goals of policymakers are to insure succession during the elections and collect the largest number of votes. One of the most popular approaches to fulfill the above-mentioned goals is increase in the government expenditures. However, these actions may put inflationary pressure on the society. Increased government expenditures are followed by reinforcement of strict regulation, government control, and bureaucratic bloat. As a result, the political power in the government hands grows leading to penalizing of the economy.

To derive this theory Buchanan studies a large spectrum of problems, to some extent related to the government functions in the area of ​​economic policy. Buchanan’s early works as "Prices, Income, and Public Policy" and "Public principles of public debt"23showed that over the past 150 years of American history budget deficits were mainly the result of wars and economic crises. In the first case, the budget deficit growth was caused by increased military spending, while in the second case by short-term declines in tax revenues. It was observed, that peacetimes and favorable economic environment were associated with budget surpluses that were used to repay public debt.

Buchanan wanted to understand the choices of the policymakers to increase budget spending on the various social programs to stimulate election processes rather than to repay debts.

Buchanan emphasizes two levels of public choice in the framework of political exchange. The first level is the development of rules and procedures of political game. The second is formation of strategic individual behavior within the laws.

The individual right and rules of relationship are set in the first stage. In public choice theory it is called the constitutional choice. Constitution is Buchanan’s key concept. The term "constitution" implies set of agreed rules that govern future actions. For example, the set of rules determining the means of financing the budget, approval of state laws, taxation, etc.

According to Buchanan, the public option can be compared to the choices people make in the course of any game. Current policy is the result of the game in the framework of constitutional rules. And just as the rules of the game determine its likely outcome, the constitutional norms form the results of the policy, or, on the contrary, make it difficult to achieve them. Therefore, the effectiveness and efficiency of policies to a large extent depend on how deeply the original constitution was drawn up.

Buchanan puts rule of unanimity for the adoption of the original constitution, since the principle of more skilled and even a simple majority in a “Direct democracy” can lead to the denial of the rights of the minority.

Buchanan’s public choice theory studies:

1) How politicians’ competition for votes leads to greater government intervention in the economy;

2) How government programs redistribute incomes from the poorest and richest to the middle class;

3) How small but cohesive political groups can win the elections over large but amorphous majority.

Buchanan's contribution to economic theory was large since he showed the importance of economic decision-making at the political level. His achievements were rewarded by the Nobel Prize (1986)24, The decision of the Swedish Academy of Sciences emphasized that Buchanan’s main achievement was in a constant and consistent emphasis on the importance of fundamental rules and application of the concept of political system as a process of exchange in order to achieve mutual benefits.

The object of the study of public choice theory is a public choice in terms of both direct and representative democracy. Therefore, the main areas of analysis are the election process, the activities of the deputies, and the economy of the bureaucracy and politics of state regulation of the economy. Similar to competitive markets representatives of the public choice theory start their analyses from “Direct democracy25”, then passing to the representative democracy as a limiting factor.

In the framework of direct democracy theory, the Scottish economist Black developed a model of so-called median voter, according to which decision-making is carried out in accordance with the interests of centrist voters (voter in the middle of the society’s scale of interests)26. At the same the decisions in favor of centrist voters have their own advantages and disadvantages. On the one hand, it keeps the community from taking extreme unilateral decisions, and from the other does not always guarantee optimal solutions for everyone. This latter is similar to the outcomes of direct democracy, where decisions adopted by majority votes may result in economically inefficient outcome (that is, overproduction or underproduction of public goods). In fact, such voting mechanism does not allow distinguishing overall benefit of an individual.

Proponents of public choice theory have shown that one cannot fully rely on the voting results, as they largely depend on specific set of rules of decision making. This problem was emphasized in the studies of Kenneth Arrow (Arrow’s Impossibility Theorem)27. Arrow believed that even under the assumptions of rationality and individual preferences, the society will not be able to determine public priorities. That is, the society is unable to form a collective opinion about what it wants. This implies that the society lacks rational preferences as a result of the violation of the assumption of transitive preferences. This phenomenon was called "paradox of voting". Paradox of voting is a contradiction arising due to the fact that the majority vote does not reveal the actual social preferences regarding the economic benefits. The most important area of public choice theory is the economy of bureaucracy.

2.3 Economy of bureaucracy

According to this theory the bureaucracy is a system of organizations that does not create economic benefits and extracts revenues from sources not related to its performance. By virtue of its position the bureaucracy is not directly related to the interests of the voters and primarily serves the interests of the legislative and executive branches. Pursuing its own interests, bureaucrats strive to make decisions that would open the access to independent use of various resources. Therefore, officials are often tied to groups representing special interests in the parliament. A common reaction to the failure of past programs is associated with increased spending and staff. All this contributes to swelling of the state apparatus - the people involved searching for "political rent" or, in other words, the desire to obtain economic rents through a political process.

Definition of a bureaucracy: Bureaucracy is a public service that exists at the expense of taxes revenues and possesses a strict hierarchy of power. The responsibilities of each are strictly defined. Bureaucrats are alienated from the results of their labor services.

The political and economic rent can be considered as special cases of economic rent. These types of rents are extracted through the political process and can be studied as an economic benefit taking into account not only direct costs.

More qualified workers can receive steady excess income or economic rent, that is, payment for their qualifications or abilities, which are considered to be scarce resources.

Economic rent is a payment for the resource whose supply is limited.

The difference between the minimum (reservation) price of labor and the market price is considered as economic rent. Under perfect competition the presence of economic rent is an incentive for the influx of new workers into the industry. Therefore, the long run competitive industry supply curve is perfectly elastic and economic rent disappears. However, in the opposite cases, economic rent may exist for a long time. This case is typical for the industries attracting unique human resources. Since the labor supply is very limited, the industry supply curve is inelastic. As a result, growth in demand is reflected in the increases in prices of labor, that is, increases in wages.

Fig. 2.3

Initial demand for labor is represented by D1 curve and supply of labor is S. With inelastic supply price of labor is entirely dependent on demand. The rise in popularity of the employee (artist, writer) means a sudden shift of the demand curve from D1 to D2. This leads wages to increase from w1 to w2. The square w1 w2 E1 E2 represents economic rent (Figure 2.3a).

Bureaucracy strengthening is a consequence of increasing economic functions of the state. Therefore, adherents of public choice theory favor the reduction of government intervention into economic activity. Government’s non-interference into the economy is justified by the presence of "government failures" that arise due to government’s inability to provide effective allocation of resources and compliance of this distribution policy with adopted community notions of justice.

Studies of bureaucracy in addition to the voters’ behavior allowed the school28 of public choice theory to greatly expand an understanding of decision-making in the public sector. As a result, the public sector has been studied on the basis of the demand and supply of the services provided

2.4. Nordhaus’s model of opportunistic business cycle

One of the first approaches to modeling the impact of political variables on the economy was developed by Nordhaus29. Nordhaus’s30 model considers voters as irrational and there are number of opportunistic parties. In this model, voters judge politicians on the basis of their past behavior and completely trust their statements without predicting future events. A politician behaves so as to maximize the number of votes during re-election. In other words, the politician represents opportunistic party and exclusively pursues political goals. The politician conducts monetary policy and determines the level of inflation and unemployment. Falling unemployment leads to increasing inflation. Hence, the politician is faced with a tradeoff between inflation and unemployment and the aggregate labor supply is well described by short-term Phillips curve.

Table 2.4

Adopted, translated version of A.Abel, &B.Bernanke, Macroeconomics (5th ed.). Pearson Addison Wesley. ISBN 0-321-16212-9.PSp.:Piter, 2010. - ( “MBA Classic” series )

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