Optimal Government Policy in a Small Open Economy with Rational Expections and Uncertain Election Outcomes

Abstract

Many of the major Western economies have recently been engaged in monetary disinflation at the expense of considerable short-term losses in output and jobs. In some of these economies there are opposition parties which promise a greater emphasis on job creation and expansion of public expenditure programs when elected into office. The possibility of a more Keynesian political party gaining office in the near future might have dra-matic consequences for the pre-election outcomes of the economy. For example, if there is a chance that demand will be stimulated in the future, the economy will anticipate the possibility of future budget deficits and rising future short-term interest rates. This implies a rise in current long real rates of interest, which combined with the appreciation of the currency can aggravate the recession caused by the monetary disinflation package implemented by the incumbent political party.2 Because the election outcome will not be known until all votes have been counted, on the morning after the election the economy will jump onto a new trajectory in order to take account of the election 'news'. It is clear, therefore, that future political uncertainty can cause major fluctuations in the current state of the economy. However, most of the literature on political business cycles (e.g., Nordhaus [1975]; MacRae [1977]; van der Ploeg [1984b]) assumes that the private sector is backward-looking, so that the effects described above do not occur. Instead, this literature assumes that the incumbent political party attempts to secure re-election, by maximizing the expected number of votes cast in its favour at the forthcoming election, and to exploit lags due to adaptive expectations. The government can then fool the electorate by judiciously depressing output in the early part of its term in office in order to force down the expected rate of inflation and by engineering a boom, without too many adverse inflationary consequences,