ECONOMY

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into their wage contracts. Meanwhile, the rationality assumption implies that voters
cannot be fooled in equilibrium—why should they vote for a policy-maker whose
futile and opportunistic attempt to stimulate employment and output yields an inflation
bias? The (theoretical) answer is that unobservable policy-maker competence
affects the real economy. Thus, the policy-maker has an incentive to stimulate the real
economy to fool the voters into believing that she is more competent than she truly is.
In equilibrium, the voters see through this incentive and anticipate the pre-election
monetary stimulus and its effects on employment and output. Even though monetary
stimulation is futile in equilibrium, the policy-maker is “forced” to go through with it
because the voters expect it; a policymaker who fails to meet the voters’ expectations
will decrease employment and output relative to what the voters expect and thus
come across as incompetent—and lose the election.
The opportunistic attempt to stimulate employment and output is necessarily
futile in equilibrium, as a consequence of the rationality assumption, and it gives rise
to a pre-election inflation bias over and above the standard inflation bias (the latter is
due to the standard time-consistency problem in monetary policy).
Rational inflation expectations and voter rationality thus imply that pre-election
monetary stimuli are futile and damaging, which in turn means that the policymaker
has an incentive to tie her hands. Not only does the policy-maker want to
prevent herself from creating an opportunistic political business cycle; she needs the
voters to know that her hands are tied. The policy-maker could, for example, delegate
monetary policy to a central banker who shares her monetary policy goals but not her
re-election goal. This can be achieved, for example, by granting the central banker a
term in office that is longer than, or staggered relative to, the policy-maker’s term in
office (Lohmann 1998b).
The second political business cycle model is due to Douglas Hibbs who in 1977
offered a partisan variant whereby two political parties represent two constituencies,
one of which prefers an easy monetary policy, or high inflation, the other a sound
monetary policy, or low inflation. As the parties succeed each other in power, monetary
policy will fluctuate over time for reasons unrelated to economic fundamentals,
in tune with the partisan control of the government. Alberto Alesina in 1987 redid the
Hibbs model by replacing adaptive inflation expectations with rational expectations.
His contribution, too, triggered a huge follow-up literature.
In the partisan case, the willingness of the two parties to commit to a monetary
institution that will implement an intermediate monetary policy in place of the
partisan political business cycle depends on the time horizon of the two parties. If
their time horizon is very short, say, if the party in office cares only about the current
period, then the party in office would have no incentives to give up the power to
set monetary policy. If both parties have long time horizons, then they can reach
a consensus to lock in the intermediate policy. This can be achieved, for example,
by setting up an independent central bank with a council that reflects the all-party
consensus (Lohmann 1997; Waller1989, 1992).
Once behavioral and experimental economics hit the system, the rationalization
obsession of macro political economy seemed misplaced. Inflation expectations are