Political Institutions and Monetary Policy

Susanne Lohmann for data used in an earlier version of the empirical analysis and participants in the Harvard Seminar in Positive Political Economy for useful comments. None of them is implicated in what follows. Abstract The degree to which voters respond to the macro-economy when deciding their vote is known to depend on institutional factors, including whether the government in power is a coalition. If this is so, then institutions should also affect the incentives for incumbent politicians to manipulate economic policy in the pursuit of votes. This paper analyzes whether political institutions do indeed affect the incentives for policy-makers to engage in " political business cycles ". Specifically, I ask whether coalition governments and single party governments behave differently with respect to electoral cycles in monetary policy. The link between government structure and electoral cycles has until now been quite under-explored, perhaps because of the difficulty of considering institutional factors in available models of political business cycles. Not only do such models assume a unitary government actor but, since voters distinguish between parties based only on expected growth, there is little theoretical support for coalition government as an equilibrium outcome. In what follows, I present a model in which voter utility depends on spatial preferences over ideology as well as real growth and inflation. This theoretical framework is consistent with coalition government as an electoral outcome and can be used for comparative analysis of different government types. The model generates a pre-electoral increase in money growth, engendered by the desire of the incumbent to increase her popularity with marginal voters. The electoral cycle, however, is smaller under coalition government for two possible reasons. First, if voters are confused about which governing party controls the economy, then the popularity gains to each party from unanticipated money growth are reduced. Second, if voters can tell which party controls macroeconomic policy, the parties that do not gain from pre-election policy manipulation have an incentive to control this behavior. Empirical testing of this hypothesis on a panel of 18 OECD countries over the period 1973 to 1992 indicates that government structure is a significant determinant of pre-electoral monetary growth. This growth is significantly higher when a single party holds power before the election. In the case of coalition government, the amount of distortion to monetary policy depends on the allocation of ministerial portfolios. In cases where different parties share responsibility for the macro-economy, …