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10.6 The Nordhaus Opportunistic Model

The modern literature on political business cycles was stimulated by the

seminal paper of Nordhaus (1975). In the electoral model popularized by

Nordhaus the party in power ‘chooses economic policies during its incumbency

which maximize its plurality at the next election’. Since voters are

influenced by a government’s macroeconomic performance before an election,

politicians will be tempted to manipulate policy instruments so that

policy outcomes are most favourable around the election period. The important

consequence of such behaviour is that policies are implemented in

democracies which are biased against future generations (see also Lindbeck,

1976; MacRae, 1977). Thus while elections and electoral competition are

necessary to increase the accountability of government, they are also likely to

introduce potentially damaging distortions into the policy-making process. In

producing this result Nordhaus makes a number of important assumptions,

namely:

N1 The political system contains two parties between which there has been

complete policy convergence as predicted by the median voter theorem

of Downs (1957).

N2 Both parties are interested in maximizing political profit rather than

engaging in ideological programmes. Only election outcomes matter to

these opportunistic non-partisan politicians.

N3 The timing of elections is exogenously fixed.

N4 Individual voters are identical and have aggregate unemployment (Ut)

and inflation (P˙t ) in their preference functions and low inflation and

unemployment rates are preferred. Policy makers are fully informed of

voters’ preferences but have no specific preferences with respect to

inflation and unemployment.

N5 Voters make political choices based on the past performance of incumbent

politicians in managing the economy during their term of office.

Not only are voters retrospective in their voting behaviour (they have

no foresight); they also have a decaying memory (a high discount rate

on past economic performance), that is, they are myopic.

N6 The macroeconomic system can be described by an expectations-augmented

Phillips curve where the short-run trade-off is less favourable

than the long-run trade-off. Voters are ignorant of the macroeconomic

framework.

N7 Expectations of inflation (P˙t )

e are formed adaptively, that is, agents are

backward-looking.

N8 Policy makers can control the level of unemployment by manipulating

aggregate demand via fiscal and monetary policies.

Nordhaus assumes (N4) that policy decisions will be based on the observed

aggregate voting function (Vt) which reflects individual preferences; this is

described by equation (10.1):

Vt = g(Ut ,P˙t ), where g(Ut ) < 0, and g(P˙t ) < 0 (10.1)

In equation (10.1) votes are a decreasing function of ˙P and U. Figure 10.3

shows the contours (iso-vote lines) of the aggregate voting function (V1, V2

and so on), which indicate the percentage of votes acquired by the incumbents

for a given policy outcome. Since inflation and unemployment are

‘bads’, V1 > V2 > V3 > V4. Voters prefer any point on V1 to any point on V2 but

are indifferent between points on the same contour. Governments seeking to

win elections will endeavour to manipulate the economy towards the highest

feasible vote contour so as to coincide with the election period.

The macroeconomic framework adopted by Nordhaus involves an expectations-

augmented Phillips curve framework summarized by equations (10.2)–

(10.5).

Expectations-augmented Phillips curve:

P˙ f (U ) P˙ t t t

= + λ e (10.2)

Adaptive expectations hypothesis:

P˙ P˙ [P˙ P˙ ], t

e

t

e

t t

− = − e > −1 α −1 −1 and α 0 (10.3)

Equilibrium condition:

P˙ P˙ t t

= e (10.4)

Long-run Phillips curve trade-off:

˙ ( )

( )

P

f U

t =

1− λ

(10.5)

Nordhaus assumes that 1 > λ > 0 which yields a long-run Phillips curve

which is less favourable (steeper) than the short-run relationship. In Figure

10.3 the short-run curves are indicated by SG, SW and SM and the position of

each curve depends on the expected rate of inflation. The long-run Phillips

curve is labelled LRPC. If the λ coefficient is unity, the Phillips curve becomes

a vertical line at the natural rate of unemployment (see Friedman,

1968a). However, as Nordhaus (1975, p. 176) notes, ‘a vertical long-run

Phillips curve makes no difference in principle’ to the substantial conclusions

of the model.