Ambiguity and Partisan Business Cycles

Abstract

We introduce ambiguity (Knightian uncertainty) into a stripped-down version of Alesina's (1987) partisan model of the business cycle. We show that, if the private sector's subjective expectations of future events are ambiguous, there is the possibility of a political business cycle, even when the parties running for the election have similar preferences for inflation and unemployment. In particular, if inflation is perceived as a loss, then the larger the fraction of the population that is ambiguity-prone (-averse), the larger is the postelection boom (slump), with unemployment then returning back to its natural level. We also show that, for given parties' preferences, ambiguity proneness (aversion) implies smaller (larger) fluctuations in the unemployment around its natural level when the right-wing party wins the elections. (JEL: D81, E32, E42; Keywords: Ambiguity, Ellsberg's paradox, Partisan theory of the business cycle, Unemployment)

Do Trade Union Leaders Violate Subjective Expected Utility? Some Insights From Experimental Data

“…36. For example, Maffioletti and Santoni (2003) apply Einhorn and Hogarth (1985) 'anchoring and adjustment model' to Alesina's partisan model of the business cycle and show that the political business cycle, under election uncertainty, depends on the ambiguity attitude of the wage setters; moreover, ambiguity proneness may indeed explain why wage setters may want to sign nominal wage contract before the election occurs.…”