Partisan Cycles and the Consumption Volatility Puzzle

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. JEL Classification: