Implications of market and political power interactions for growth and the business cycle II: politico-economic equilibrium

Abstract

Motivated by the politico-economic systems encountered in many countries all over the globe, including those of several Southern European countries. In this paper we follow a Ramsey type optimal policy approach to endogenize government policy in the two sector DSGE model with market and political power interactions developed in a companion paper. We thus obtain what we call the politico-economic equilibrium. That is, a contingency plan for the economy’s resource allocation and government policy variables that optimize the government’s objective function, subject to the private sector equilibrium. The government’s objective function seeks a balance between pursuing the interests of insiders and the interests of the representative household. The latter are in line with what Jean Tirole calls government pursuing policies for the “the common good.” We take the interests of insiders to be represented by the expected value of their income. The combination of these two defines what we call the “Hybrid” government. We then investigate the growth implications of the politico-economic equilibrium, focusing, first, on the steady state comparison of the hybrid government politico-economic equilibrium relative to the Second Best allocation implied by the Canonical Real Business Cycle economy; and second, on the asymptotic steady states of the politico-economic equilibrium of a Hybrid government in a detailed economy, for different degrees of insiders’ influence in government. We find that increasing influence of insiders in government decision making is quite bad for the economy. The degree of influence of insiders is a deep parameter of the model that can be estimated in the data and thereby rank countries accordingly. The extent of this influence may explain the different macroeconomic performance observed among countries that, ceteris paribus, enjoy a similar state of development.