Economy experiences macroeconomic fluctuations over time that affects economic growth. The aggregate output, consumption, investment, net export, and employment may tend to grow over time but then drop suddenly. Economists continue to discern the current condition of the economy and where it is heading so that they can effectively deal with future economic events. Macroeconomic fluctuations mainly involve changes that occur in the demand-side of the economy, which determine the gross domestic product.
Gross domestic product is never constant, but change due to many reasons like changes in government policies mainly in interest rates and taxes. Different economics theories have evolved over time to explain macroeconomic fluctuations.
– Political Business Cycle (Rational partisan political business cycle models)
Political economists continue to study and research how politician pressures and interest groups within a country can lead to macroeconomic fluctuations. Political business cycle explains business cycles resulting from the manipulation of policy tools (monetary and fiscal policy) by incumbent governments so that they can get re-elected and stay in office (Paldman 342). These governments hope to stimulate the economy just before general elections for them to improve their parties’ re-election chances. The cycle explains the interaction between macroeconomic and political variables in the election of new governments through focusing at the dynamics between the incumbent and the electorate. According to this cycle, the voters maximize their individual utilities, while the incumbent is expected to implement the policies that allowed it to retain power. Expansionary fiscal and monetary policies have many favorable consequences in the short run such as creation of jobs, fall in interest rates, tax cuts, and increase in government spending to stimulate economic growth. However, the same fiscal and monetary policies have other very unpleasant consequences such as damage of foreign trade balance and accelerating inflation. Others include low rate of savings to support investments, and long-term expansion of the government share of the gross domestic product at the citizens’ disposable income. After elections, politicians may manipulate powers by raising taxes, allowing interest rates to rise, slowing the growth of the money supply, and by cutting spending. These actions continue until just before the next election. Therefore, holding of elections at regular intervals facilitates macroeconomics fluctuations (a boom and bust pattern).
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Rational partisan Business Model
The model of rational partisan predicts that macroeconomic fluctuations are triggered by any possible change in government policies as a result of elections. In this model, agents face uncertainty regarding the outcome and timing of the next election. It further predicts that the partisan influence on the state of the economy persists throughout the current government’s rule. The state of the economy is further influenced by the party that ruled before the current one. Moreover, the popularity of the party also has a significant influence on the macroeconomic fluctuation.
Rational partisan model involves a two-party political system whereby each of these two parties has its policy platform (Alesina 58). While the left-wing party fights for growth and unemployment, the right-wing party is more concerned in fighting inflation. The left-wing governments’ core constitutions are composed of blue-collar workers and are more vulnerable to unemployment during economic downturns. The right-wing party is made up of white-collar professionals whereby their employment prospects have been much more stable over time. This group is concerned with retaining the real value of its asset through low inflation. The key parties are the electorate, but not political candidates, where each voter elects the candidate he/she thinks better suits his/her preferences according to party platforms.
In this model, policy is uncertain in the presence of election, because the election winner (and the future controller of policy), is not known with certainty. This uncertainty leads to short-term business cycle effects (macroeconomic fluctuations) as the agents then form inflammatory expectations (as a weighted average) of the parties’ expected policies. In the end, each election held leads to new and different inflation rate from the expected one. If the left-wing party wins, there is a high expectation that inflation will rise, and the economy is to grow more rapidly than normal. However, if the right-wing side is victorious, there is an economic downturn due to unemployment, low government spending, and low inflation. In short, the rational partisan model predicts that regular elections usually lead to temporally macroeconomic fluctuations due to the existence of uncertainty over elections outcomes. In addition, the winning party determines the direction of the fluctuation.
A rational partisan business model explanation framework
As above, rational partisan business model differs from traditional partisan in that a voter forms inflation expectation rationally and that the elections’ outcomes are uncertain. In addition, politicians in partisan business model have different preferences. The right-wing party focuses on economic growth and unemployment and the left-wing party fights inflation.
Let us consider two political parties N and M. Party N is more concerned about fighting inflation that focusing on growth and unemployment, and party M is more concerned with economic growth and unemployment than inflation.
UN = – (YT – XN )2 + BNJT ; XN > 0, BN > 0
UM = – (YT – XM )2 + BMJT ; XM > 0, BM > 0
In the formulas, the subscripts N and M denote the two parties (Alesina n. p). In the formulas, XN and XM represent the targets rate of inflation of the parties N and M respectively in their policy platform. In addition, since the economic rate states that the optimal level of inflation is never zero, the target rate of inflation of the two parties is positive. BN and BM represent the benefits of these two parties. The relative references of these parties (inflation, unemployment and growth) are represented by XM > XN > 0 and BM > BN > 0.
Since voters have different preferences based on unemployment and inflation, they tend to elect candidate that they think would deliver the highest expected utility. It is the reason voters who prefer low inflation levels would vote party M and those who are more concerned with unemployment would vote for party N.
The model stresses that apart from the winning party, the level of inflation and hence economic growth will much depend with on the degree of political polarization. Polarization refers to how different are policy platforms. This argument is backed by Alesina and Rosenthal, who stress that political polarization creates wider economic fluctuation (176).
As a summary of the above presentation, if the party N wins, inflation would increase above expectations and also the output would grow above its natural level. In the other side, if M wins, inflation would be below the expected levels, and the output or economic growth would be below its natural rate. The total output will be expected to return to its natural level in the second period (next election) regardless of the party that will win. This observation is due to the inflation expectation (wages) adjustment in the economy. The cycle between the output, employment and inflation will continue causing macroeconomic fluctuation if election will continue to be held.
Real world example of rational Partisan Models
Research prove that over the years, the United States gross domestic product (GDP) growth is substantially lower under Republicans than Democrats in the second and theirs year of their administrations. Between 1949 and 1994, the growth rates during republican and during democrats’ administrations sharply diverge starting from the third quarter after the election. Moreover, the quarterly rate of growth averaged over Democrats administration increases from 3% per annum in the third quarter to 6% by the seventh quarter in the administration’s term of office. However, it falls from the same level to zero by the seventh quarter in the term of administration averaged over republican administration. After some time, the economic performance under the two parties becomes identical (Drazen 8).
The word count for Rational Partisan Political Business Cycle is 1260
– The post-Keynesian Paradigm
The post-Keynesian paradigm is a collection of emerging schools of economic thoughts that attempt to reflect the basics and the work of John Maynard Keynes. Although these schools are much related to the work done by Keynes, they have introduced new insights and ideas not found in Keynes book, and that can help explain macroeconomic fluctuations. It is the study of the economy carried out after 1936 (King 10).
Effective demand and macroeconomic fluctuations
The principle of effective demand is the post-Keynesian paradigm main focus. This theory defines effective demand as the actual quantity of products buyers are purchasing in a given market. It exists when buyers are both able and willing to purchase a product. In the aggregate market for products, effective demand is the same as aggregate demand when the demand for products is influenced by spillovers from the amount of goods constraints from other markets.
In a free private enterprise, manufacturers would aim at producing as many goods and services as possible to sell profitably. If the expenditure of these goods (aggregate demand) is large, these manufacturers, suppliers and entrepreneurs will not only sell high quantities of goods and services profitably, but will have an incentive to produce more. For them to produce more products, they must employ more resources in terms of people (workers) and materials. In other words, higher levels of aggregate demand will lead to greater income, output, and employment and hence economic growth (Harvey 384). However, if the level of expenditure or aggregate demand is low, the result is selling smaller amount of goods and services profitably hence negatively affecting economic growth.
Low aggregate demand means that the total quantity of the national output produced will also not be high. In addition, this low production will also require a smaller amount of resources. The result is unemployment of resources particularly capital and labor. In short, the change in aggregate effective demand levels will facilitate macroeconomic fluctuations based on the level of employment, output, and income. According to post-Keynesian paradigm, macroeconomic fluctuations usually occur due to the aggregate effective demand fluctuations and future uncertainty (Rousseas 12). If aggregate effective demand continues to fall, this action will eventually create the conditions of depression or recession. It is only through increasing the aggregate demand that the economic expansion would take place.
Fluctuation of aggregate demand depends on both the demand for investment goods and the demand for consumption goods. Since the propensity to consume is somehow stable in the short run, aggregate demand fluctuation will much depend on the fluctuations in investment demand. Any fluctuation in investment demand (since it is very unstable) will result in macroeconomics fluctuations.
During economic expansions phases, increase in demand for capital goods as a result of large investment activity makes the price of capital goods to rise due to increasing marginal cost of their production. Increase in prices of capital goods raises the investment project costs thus reducing marginal efficiency of capital. In addition, during this phase, the demand for money increases, thus raising interest rate. Increase in interest rates makes investment projects unprofitable. All these actions (increase in interest rates and fall in the marginal efficiency of capital) lead to declining in investment demand. It is through all these cycles in investment demand and consumption goods that lead to the fluctuation in aggregate demand, which in turn result to an unstable economy.
Monetary policy and money supply
Monetary policy refers the actions of the central bank or other regulatory bodies that determine the rate and size of the money supply in the economy. It is determined through activities such as change in the amount of money a bank needs or increase in the interest rates. Post-Keynesian economists believe that there is an indirect relationship between money supply and the real GDP. They state that expansionary monetary supply has the effect of increasing the supply of loanable funds, which in turn causes a fall in interest rates. The decrease in interest rates makes aggregate expenditures on interest-sensible consumption goods and on investment to increase, causing real GDP to rise.
If we focus on the real world, a fall in interest rate makes it cheaper for people to borrow money and households are now able and more willing to purchase goods and services. In addition, firms are also in a better position to buy items such as equipment and property to expand their businesses. Firms then hire more workers and boost production due to an increase in total (business and household) spending. As a result, household wealth increases and further spurs more spending. All this action boosts the economy.
However, if this money supply grows too fast, increase in demand for commodities pushes wages and other costs higher and reflect the greater demand for materials and workers that are necessary for the production. In other words, it causes inflation (Beryl 366). High inflation may increase the opportunity cost of holding money, lead to a shortage of goods as customers hold money, and discourage investments. If the investment is lower than saving, recession occurs. If the investment is higher than saving, the economy experiences inflation. It is the reason that governments discourage people from holding money and encourage spending. Governments usually borrow money and push it into the economy to facilitate spending. In addition, when some people spend and others earn, they create a cycle that improves the economy. During World War II, when the great depression hit Europe, people made a huge mistake of holding money. By doing so, they stopped the circulation of money, which put their economy at a standstill.
Post-Keynesian economists stress that a poor control of monetary policy usually leads to macroeconomic fluctuations due to fluctuations in interest rates and inflation. Low and steady inflation rate reduces severity of recessions since it enables the labor market to adjust more quickly in a downturn. This action reduces the risk of a liquidity trap from preventing monetary policy from stabilizing the economy (Escape from liquidity 158).
The post-Keynesian paradigm advocates the increase on government spending or for the government to cut tax or both. The logic behind this argument is that insufficient total demand and services are some of the main factors that can lead to recessions. If savings are higher than investments, demand will not be enough to buy all commodities that a particular economy would produce at the full employment level. There will be spillover and firms will reduce output since some goods will not be sold. These firms will eventually cancel supply orders, cut jobs, or even close production facilities. These actions will lead to a recession.
According to post-Keynesian paradigm, the only way to save the economy from a recession and increase total demand, output and employment is by either increasing government spending or cutting taxes. These actions help increase income for workers and open new opportunities for more employees, thus boosting the economy.
However, even though post-Keynesian paradigm advocates on government spending to boost or stabilize the economy, it stresses that the level of inflation limits government spending. Too much of government spending leads to economic growth, which in turn makes the money supply in the central bank to grow too quickly than the economy, thus leading to inflation. It is the reason central banks and other regulatory committees should control money supply to stabilize the economy.
The word count for The Post-Keynesian Paradigm is 1230
Alesina, Alberto and Rosenthal. “ Partisan Politics, Divided Government and the Economy.” Cambridge University Press (1995): 161-187. Print
Alesina, Alberto. “ Macroeconomic Policy in a two-party system as a repeated game”. Quarterly Journal of Economics 102, (1987): 651-78. Print
Berly, Sprinkel (1986). “ Monetary Policy and The Business Cycle.” Cato Journol 6, 2 (1968): 365-367. Print
Drazen, Allan. “ The Political Business Cycle after 25 Years.” NBER Macroeconomics Annual 15 (2000). Print
” Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others” Lars E. O. Svensson, Journal of Economic Perspectives 17, 4 (2003): 145–166. Print
Harvey, J. T. “ United States Business Cycles from 1971 through 2010: A Post Keynesian Explanation”. Journal of Economic Issues (M. E. Sharpe Inc.) 45, 2 (2011) 381-390. Print
King, John. A history of post Keynesian economics since 1936. Edward Elgar Publishing, 2002. Print
Paldman, M. “ Is There an Electoral Cycle? A Comparative of National Accounts.” Scandinavian Journal of Economics 81 (1979): 323-42. Print
Rousseas, S. Post-Keynesian Monetary Economics, London: Macmillan, 1986. Print