Partisan Cycles and the Consumption Volatility Puzzle

Abstract

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.

Public consumption over the business cycle

“…Finally, this paper relates to a literature on the business cycle patterns of government expenditures in emerging market economies: see Alesina, Campante, and Tabellini (2008), Parmaksiz (2010), Ilzetzki (2011), and Azzimonti and Talbert (2011). This research focuses on the role of sovereign borrowing constraints as well as the role of financial and political frictions for the excess volatility and procyclicality of fiscal policies in emerging markets.…”

“…A number of authors have studied the amplification and propagation mechanisms of public expenditure in response to aggregate shocks, including total factor productivity (TFP) shocks (Ambler and Paquet (1996), Barseghyan, Battaglini, and Coate (2010), Debortoli and Nunes (2010), Azzimonti and Talbert (2011), Bachmann and Bai (2013)), preference shocks (Battaglini and Coate (2008), Azzimonti, Battaglini, and Coate (2010), Yared (2010)), commitment shocks (Debortoli and Nunes 3 A complementary literature on endogenous public policy focused on deterministic policy dynamics: in addition to KKR, see Krusell, Quadrini, and Rios-Rull (1997), Krusell and Rios-Rull (1999), Hassler et al (2003Hassler et al ( , 2005, Corbae, D'Erasmo, andKuruscu (2009), Martin (2010), Azzimonti (2011), Lagunoff (2011), andSong, Storesletten, andZilibotti (2012). (2010,2013)), and political uncertainty shocks (Woo (2005), Azzimonti and Talbert (2011)). In particular, Azzimonti and Talbert (2011) share common elements with our paper, but with a focus on the effects of TFP and political uncertainty on emergingmarket consumption volatility.…”

“…(2010,2013)), and political uncertainty shocks (Woo (2005), Azzimonti and Talbert (2011)). In particular, Azzimonti and Talbert (2011) share common elements with our paper, but with a focus on the effects of TFP and political uncertainty on emergingmarket consumption volatility. Like the preference shocks in this paper, the political uncertainty in their model increases the volatility of public consumption and dampens the contemporaneous co-movement between government spending and GDP.…”

Time-consistent optimal fiscal policy over the business cycle

“…Second, this paper is related to research on endogenous fiscal policies over the business cycle (e.g., Azzimonti and Talbert (2011), Bai (2013a, 2013b), Barseghyan, Battaglini, and Coate (2010), Chari, Christiano, and Kehoe (1994), Debortoli and Nunes (2010), Klein and Ríos-Rull (2003), and Stockman (2004)). I focus on equilibria that are supported by reputation and satisfy time consistency.…”

External Shocks and High Volatility in Consumption in Low‐Income Countries

“…One appropriate approach to the puzzle of high consumption volatility is an analysis based on a DSGE model, which was developed to examine fluctuations in macroeconomic variables. Levchenko (2005), Neumeyer andPerri (2005), Resende (2006), Aguiar and Gopinath (2007), Alvarez-Parra, Marques, andToledo (2011), andAzzimonti andTalbert (2011) all employ the DSGE model to address this puzzle. I suggest, in this research, another mechanism that has not been deeply examined in the literature.…”