The Political Economy of Overvaluation

Abstract

Most of the literature on political business cycles (e.g. Nordhaus, 1975; MacRae, 1977; van der Ploeg, I984) assumes that the incumbent political party attempts to secure re-election, by maximising 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 to create a boom, without too many adverse inflationary consequences, towards election eve in order to gain the sympathy of the electorate. Such political business cycles rely on a naive electorate and cannot occur in New Classical economies with market clearing and rational expectations, because then the electorate would see through the government's vote-maximising strategy (e.g. McCallum, 1978; Minford and Peel, I982). If the private sector has rational expectations and prices or wages are sticky, this is observationally equivalent to adaptive expectations and flexible prices and wages (e.g. Sargent, 1976) but nevertheless the electorate would see through a vote-maximising strategy and thus no political business cycle would occur. In any case, it is not clear that the empirical evidence supports this view of the political business cycle (e.g. Frey, 1978). One reason for this is that it may not be realistic to assume that output can be changed instantaneously whilst inflation can, through expectations, only be influenced in a gradual fashion. In an open economy it is much easier and faster to affect real income and consumers' prices through the exchange rate than it is to have an effect on aggregate demand, output and employment. An appreciation of the exchange rate immediately cuts import prices and consumers' prices and therefore immediately boosts real income. This, combined with the reduction in the real value of imports, depresses aggregate demand, but over time standard neoclassical substitution effects ensure that the volume of exports decreases, the volume of imports decreases and therefore aggregate demand and output increase. The above argument is based on the J-curve effect in the balance of trade, for which there is ample empirical evidence (e.g. Diaz-Alejandro, 1966; Magee, 1973). This note explores the implications of the J-curve effect for the political business cycle in a small open economy, as suggested by van der Ploeg (I984) and Dornbusch (I987, Section iv). Section I sets up the model of the economy. Section II derives the development of the exchange rate, real income and output over the course of the political business cycle. Section III concludes with an interpretation and qualification of the results.