We study a simple general equilibrium model with two sectors and two political parties, where each party represents the agents working in one of the sectors. The size of the sectors is endogenous since the government can set a minimum wage in one of the sectors. It is shown that there may be a continuum of political–economic equilibria, and that endogenous political business cycles can emerge.
There is a close interaction between politics and economics. Political decisions influence the functioning of the economy and the performance of politicians is evaluated according to the state the economy is in. This interaction between politics and economics may result in a situation of economic inefficiency.1 It may in particular cause the emergence of so-called political business cycles, that is, fluctuations in prices, employment and output arising from the competition between political parties.
In this paper, we study a simple general equilibrium model with endogenous political behaviour and show that economically inefficient equilibria and political business cycles may emerge endogenously. The mechanism driving these results differs from the mechanisms identified in the earlier literature on political business cycles.
In voting theory, it is usually assumed that political parties select platforms in a way that maximizes the probability of being elected. Suppose there are two political parties, the policy space is one-dimensional and voting behaviour is deterministic, that is, an agent votes for the political party closest to his ideal point. Then the well-known median voter result follows: both political parties choose a platform coinciding with the ideal point of the median voter. 2 Nordhaus (1975) shows that in such a model an opportunistic political business cycle might emerge. The incumbent party stimulates the economy prior to an election, for example, by trading off a higher inflation rate and a lower unemployment level, in order to be re-elected. After the election, the government lowers the high inflation rate, which leads to a reduction of employment again. The model therefore predicts an upswing of the economy just before each election and a downswing after an election. This political business cycle only emerges if agents form expectations adaptively, 3 or if there is some information asymmetry between the government and voters. A number of contributions have criticized the assumption that political parties only care about winning elections (for example Wittman, 1977, Alesina, 1987 and Alesina and Rosenthal, 1995). Rather, it has been argued that political parties have certain preferences and different political parties execute different policies when elected. 4 A “left-wing” political party may choose policies to reduce unemployment and a “right wing” party may choose policies focusing on lowering inflation. A business cycle may arise since, if a left-wing party is elected, inflation will rise and, if a right-wing party is elected, inflation will decrease. Business cycles emerging in this way are called partisan business cycles (Alesina (1987)). A necessary condition for these partisan business cycles to exist is incomplete information about voter preferences (see Alesina and Rosenthal, 1995).
In these partisan models party preferences are given exogenously. In this paper we study the behaviour of a political-economic model with two parties where party preferences differ because parties represent different groups in the economy. An important aspect of our model is that the sizes of these groups are determined endogenously and depend upon government policies. In particular, the size of the group might decrease when the political party representing this group is in office. This occurs because a policy that is beneficial to an average individual member of this group may cause a number of members of this group to transfer to the other group.
As a very simple example, consider an economy where agents can be divided in two groups, the “rich” and the “poor”, for lack of better terminology. If the political party representing the poor is in office, it will devise policies such that the average poor agent will be better off, resulting in some poor people becoming rich, which decreases the number of poor people and increases the number of rich people. If, on the other hand, the party representing rich people is in office and if we make the realistic assumption that income for a rich agent is a decreasing function of the number of rich people,5 then this political party will execute policies that will at least not increase, and possibly decrease, the number of rich people. In this way, an endogenous political business cycle emerges.
We study these ideas in a simple general equilibrium model with two sectors, one of which uses high-skilled labour and the other low-skilled labour, where the number of people working in each sector is determined endogenously. A political party in office can impose a minimum wage to redistribute income in favour of the group it represents. We study the existence of a political economic equilibrium. Several situations may occur: (i) the Walrasian equilibrium may be a political–economic equilibrium, (ii) there may be a continuum of political–economic equilibria, possibly including the Walrasian equilibrium and (iii) a political–economic equilibrium may not exist, in which case an endogenous political business cycle emerges.
Our model is similar to that of Herings (1997), who shows that price rigidities may emerge endogenously in a general equilibrium model through competition for votes between two political parties.
The outline of the rest of the paper is as follows. In Section 2, we describe the model and show what can happen if a government can set a minimum wage for high-skilled labour. In Section 3, we study what happens if the government can set a minimum wage for low-skilled labour. Section 4 discusses the results.
