PDF Ebook Fiscal Policy over the Real Business Cycle: A Positive Theory
Real business cycle theory develops the idea that business cycles can be generated by random fluctuations in productivity. At the core of this research program, the fundamental issues are how individuals react to productivity shocks and how these reactions affect the macro economy. While the issue of reaction to shocks is typically studied at the individual level, it can also be raised at the societal level. How do individuals, through their political institutions, collectively decide to adjust fiscal policies in response to changes in productivity? Moreover, what is the role of changes in fiscal policy in amplifying or dampening shocks? Though understanding individual responses to shocks can be addressed with the tools of basic microeconomics, understanding societal responses requires a study of how collective choices are made in complex dynamic environments.
In the last two decades, political economy has made important progress, both theoretically and empirically, in understanding how governments function and the type of distortions that the political process generates in an economy. This first generation of research, however, has largely focused on static or two period models that are not well suited to answer the questions raised by real business cycle theory. When longer time horizons are considered, other important elements of the environment (such as shocks, rational forward looking agents, etc) are muted. Thus, the basic question as to how governments react to business cycles is not well understood. Because of this, empirical analysis on the cyclical behavior of fiscal policy remains largely guided by normative models of policy making.
In Battaglini and Coate (2008), we proposed a dynamic political economy theory of fiscal policy. Our framework begins with a tax smoothing model of fiscal policy of the form studied by Barro (1979), Lucas and Stokey (1983), and Aiyagari et. al. (2002). The need for tax smoothing is generated by shocks in the benefits of public spending created by events like wars and natural disasters. Politics is introduced by assuming that policy choices are made by a legislature rather than a benevolent planner. Moreover, the framework incorporates the friction that legislators can redistribute tax dollars back to their districts via pork-barrel spending. The theory yields clean predictions on how fiscal policy responds to public spending shocks and provides a sharp account of how politics distorts economic policy-making.
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PDF Ebook Fiscal Policy over the Real Business Cycle: A Positive Theory
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