We are motivated by four stylized facts computed for emerging and developed economies: (i) business cycle movements are wider in emerging countries; (ii) economies in emerging countries experience greater economic policy uncertainty; (iii) emerging economies are more polarized and less politically stable; and (iv) economic policy uncertainty is positively related to political polarization. We show that a standard real business cycle (RBC) model augmented to incorporate political polarization, a 'polarized business cycle' (PBC) model, is consistent with these facts. Our main hypothesis is that fluctuations in economic variables are not only caused by innovations to productivity, as traditionally assumed in macroeconomic models, but also by shifts in political ideology. Switches between left-wing and right-wing governments generate uncertainty about the returns to private investment, and this affects real economic outcomes. Since emerging economies are more polarized than developed ones, the effects of political turnover are more pronounced. This translates into higher economic policy uncertainty and amplifies business cycles. We derive our results analytically by fully characterizing the long-run distribution of economic and fiscal variables. We then analyze the effect of a permanent increase in polarization on PBCs.

We are motivated by four stylized facts computed for emerging and developed economies: (i) business cycle movements are wider in emerging countries; (ii) economies in emerging countries experience greater economic policy uncertainty; (iii) emerging economies are more polarized and less politically stable; and (iv) economic policy uncertainty is positively related to political polarization. We show that a standard real business cycle (RBC) model augmented to incorporate political polarization, a 'polarized business cycle' (PBC) model, is consistent with these facts. Our main hypothesis is that fluctuations in economic variables are not only caused by innovations to productivity, as traditionally assumed in macroeconomic models, but also by shifts in political ideology. Switches between left-wing and right-wing governments generate uncertainty about the returns to private investment, and this affects real economic outcomes. Since emerging economies are more polarized than developed ones, the effects of political turnover are more pronounced. This translates into higher economic policy uncertainty and amplifies business cycles. We derive our results analytically by fully characterizing the long-run distribution of economic and fiscal variables. We then analyze the effect of a permanent increase in polarization on PBCs.

Standard real business cycle theory predicts that consumption should be smoother than output, as observed in developed countries. In emerging economies, however, consumption is more volatile than income. In this paper we provide a novel explanation of this phenomenon, the 'consumption volatility puzzle', based on political frictions. We develop a dynamic stochastic political economy model where parties that disagree on the size of government (right-wing and left-wing) alternate in power and face aggregate uncertainty. While productivity shocks affect only consumption through responses to output, political shocks (switches in political ideology) change the composition between private and public consumption for a given output size via changes in the level of taxes. Since emerging economies are characterized by less stable governments and more polarized societies, the effects of political shocks are more pronounced. For a reasonable set of parameters we confirm the empirical relationship between political polarization and the ratio of consumption volatility to output volatility across countries.

Standard real business cycle theory predicts that consumption should be smoother than output, as observed in developed countries. In emerging economies, however, consumption is more volatile than income. In this paper we provide a novel explanation of this phenomenon, the 'consumption volatility puzzle', based on political frictions. We develop a dynamic stochastic political economy model where parties that disagree on the size of government (right-wing and left-wing) alternate in power and face aggregate uncertainty. While productivity shocks affect only consumption through responses to output, political shocks (switches in political ideology) change the composition between private and public consumption for a given output size via changes in the level of taxes. Since emerging economies are characterized by less stable governments and more polarized societies, the effects of political shocks are more pronounced. For a reasonable set of parameters we confirm the empirical relationship between political polarization and the ratio of consumption volatility to output volatility across countries.