Political business cycles and central bank independence

Abstract

This paper develops a dynamic model of Rational Partisan Business Cycles in which wage contracts overlap elections and wage setters have to make a prediction about the election result. Empirical analysis of 20 OECD countries supports the theoretical implication that left wing incumbents increase output, but increased expectation of a left wing regime reduces it. The model is extended to incorporate the effects of alternative measures of Central Bank Independence (CBI). The measure of objective independence outperforms the other measures and it is found that CBI reduces politically induced business cycles.