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10.6.3 Short-run outcomes: the ‘political business cycle’

In his analysis of short-run behaviour, Nordhaus introduces the possibility

that voters have a ‘decaying memory’ (assumption N5). Voters place more

weight on recent events than distant events from the past. In this case equation

(10.1) is replaced by (10.7), where T is the length of the electoral period

and z is the decay rate of voters’ memories:

VT g U P dt


t t e

= ∫ zt 0

( , ˙ ) (10.7)

The modified vote function (10.7) indicates that although voters hold the government

responsible for inflation and unemployment in the current period, their

decaying memory provides the incumbents with the opportunity to systematically

fool the electorate. A typical short-run political business cycle would

progress as follows. As before, suppose the economy is initially located at point

G in Figure 10.3 in the period immediately preceding an election. By expanding

aggregate demand the government can lower unemployment and achieve a

position such as E1, which will generate more votes than is possible at G (that

is, V1 > V2). The cost of this manoeuvre is a (delayed) acceleration of inflation

(SG eventually shifts up to the right as expectations adjust). However, this cost

tends to arise after the election has already been won. Even if inflation accelerates

just before the election, with adaptive expectations it will take time for

economic agents and voters to realize that inflation has increased. Having

caused higher inflation, the government now needs to reduce it. Therefore,

immediately following an election victory the government will deflate aggregate

demand which, by increasing unemployment, will eventually reduce

inflationary expectations, thereby shifting the short-run Phillips curve back

towards SG. Because voters have a decaying memory, this strategy can be

repeated at the next election: recent events are ‘more poignant’ than ‘ancient

ills’. Hence the government can benefit from opportunistic behaviour which

deliberately destabilizes the economy to produce a politically induced business

cycle. This outcome is clearly at odds with the basic Keynesian notion that a

major objective of government is to stabilize the economy.

The Nordhaus model gives clear predictions about the pattern of unemployment

and inflation during the electoral cycle. In the first half of an

electoral period unemployment should be rising, GDP falling and inflation

(eventually) falling. In the run-up to an election, the second half of the

electoral period should be characterized by falling unemployment and rising

GDP. In the immediate post-electoral period inflation rises and a recession

sets in. Nordhaus tested this hypothesis for nine countries over the period

1947–72 and concluded that ‘given both casual and formal evidence of economic

behaviour, and the historical record in the countries examined, it is

clear that a political business cycle is a significant factor in the operation of

some capitalist economies’ (Nordhaus, 1975, emphasis added). Later, Nordhaus

(1989) argued that there can be no monocausal explanation of the political

influences on economic cycles, but in his view the impact of ideological

considerations remained secondary to opportunistic behaviour.

Perhaps the best example of opportunistic behaviour was observed towards

the end of the first term of Richard Nixon’s Presidency in the USA. The

deliberately induced 1970–71 recession was quickly reversed by expansionary

policies in the run-up to the 1972 election. According to Tufte (1978),

Nixon ensured that all social security recipients received a letter in the period

just before the 1972 presidential election. With each letter was a cheque

containing a social security benefits increase of 20 per cent. Apparently

Nixon was concerned that his defeat by Kennedy in 1960 was due to the

failure of President Eisenhower to reflate the economy. It is therefore hardly

surprising that Richard Nixon has been described by Rogoff (1988) as the ‘all

time hero of political business cycles’.

Given the potentially serious nature of this phenomenon, Nordhaus suggested

a number of possible remedies which included increasing the

information available to voters and entrusting monetary policy to an independent

central bank (see section 10.13).