Essays on Political Institutions and Macroeconomics

This dissertation consists of three chapters on the interaction of political institutions and macroeconomic activity in dynamic environments. Chapter 1 studies the optimal management of taxes and debt in a framework which relaxes the standard assumption of a benevolent government. We assume instead the existence of a self-interested ruler who manages the government budget. Unlike in the standard economy, temporary economic shocks generate persistent changes in taxes and debt along the equilibrium path so as to optimally limit rent-seeking by the ruler. The presence of political economy distortions causes the debt market which is complete to behave as if it were incomplete. In contrast to an incomplete market economy, taxes are positive in the long run. A numerical exercise suggests that the welfare cost of political economy distortions is high if the government chooses suboptimal politically sustainable policies which do not respond persistently to shocks. This is because the government over-saves and resources are wasted on rents. Chapter 2 studies the dynamics of war and peace in an environment with two groups seeking resources from each other. Peaceful compromise is subject to limited commitment and informational frictions since groups cannot commit to concession-making and the private cost of concession-making can be extremely high. We show that phases of war enforce phases of peace along the equilibrium path. Even though fluctuations between war and peace can occur in the short run, long run convergence to permanent war is inevitable since this maximizes the duration of peace in the short run. In an extension, we allow each group to waste resources during war to inflict additional damage on its enemy. Under some conditions, phases of peace occur even in the long run, since phases of peace enforce phases of war. Chapter 3 is joint work with Daron Acemoglu, Simon Johnson, and James A. Robinson. We revisit the conventional wisdom which views high levels of income as a prerequisite for democracy. We show that existing evidence for this view is based on cross-country correlations which disappear once we look at within-country variation. Rather than reflecting causality, the cross-country correlation between income and democracy reflects longer-run changes, in particular, a positive correlation between changes in income and democracy over the past 500 years. We suggest a possible explanation for this pattern based on the idea that societies may have embarked on divergent political-economic development paths at certain critical junctures. Thesis Supervisor: Daron Acemoglu Title: Charles P. Kindleberger Professor of Applied Economics