Working Paper No. 13-44 Polarized Business Cycles

We are motivated by four stylized facts computed for emerging and developed economies: (i) business cycle movements are wider in emerging countries; (ii) economies in emerging countries experience greater economic policy uncertainty; (iii) emerging economies are more polarized and less politically stable; and (iv) economic policy uncertainty is positively related to political polarization. We show that a standard real business cycle (RBC) model augmented to incorporate political polarization, a ‘polarized business cycle’ (PBC) model, is consistent with these facts. Our main hypothesis is that fluctuations in economic variables are not only caused by innovations to productivity, as traditionally assumed in macroeconomic models, but also by shifts in political ideology. Switches between left-wing and right-wing governments generate uncertainty about the returns to private investment, and this affects real economic outcomes. Since emerging economies are more polarized than developed ones, the effects of political turnover are more pronounced. This translates into higher economic policy uncertainty and amplifies business cycles. We derive our results analytically by fully characterizing the long-run distribution of economic and fiscal variables. We then analyze the effect of a permanent increase in polarization on PBCs. JEL Classification: E3, H3