Download Wage Inflation, Electoral Uncertainty and the Exchange Rate Regime

Wage Inflation, Electoral Uncertainty and the Exchange Rate Regime: Theory and UK
Evidence
Author(s): George S. Alogoskoufis, Ben Lockwood, Apostolis Philippopoulos
Source: The Economic Journal, Vol. 102, No. 415 (Nov., 1992), pp. 1370-1394
Published by: Blackwell Publishing for the Royal Economic Society
Stable URL: http://www.jstor.org/stable/2234795 .
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TheEconomicJournal,I02 (NovemberI992),
I370-I394
Printedin GreatBritain
WAGE INFLATION,
ELECTORAL UNCERTAINTY
AND THE EXCHANGE RATE REGIME:
THEORY AND UK EVIDENCE*
GeorgeS. Alogoskoufis,
Ben Lockwood
andApostolisPhilippopoulos
Recent developments in the theory of inflation stress the limited ability of
governments to pre-commit to price stability. When governments can create
unanticipated inflation in order to reduce unemployment, expected inflation
will rise to the point where the marginal cost of inflation to the authorities is
so high, that they will have no further incentive to create unanticipated
inflation (Kydland and Prescott, I977; Barro and Gordon, I983a, b).
Applications of this approach include the partisan model of inflation (Alesina,
I987) and the exchange-rate-regime model of inflation (Giavazzi and
Giovannini, I987), the latter being an extension of Rogoffs (I985) solution of
appointing a conservative central banker.
The partisan model emphasises that parties have different preferences for
inflation and unemployment. The party that is relatively more averse to
unemployment (say the 'socialists') will have stronger incentives to inflate. As
these incentives will be anticipated by wage-setters, 'socialist' parties will be
associated with higher expected and actual inflation than 'conservative' ones,
although they will not be able to affect unemployment systematically, except
in the period following an election. In such a period, with nominal wages
having been set before the announcement of the election result, if there is a
socialist (conservative) victory, inflation will be higher (lower) than wage
setters anticipated, and thus unemployment will temporarily fall (rise)*1
The exchange-rate-regime model captures one of the institutional mechanisms that can help avoid the unpleasant outcome of high equilibrium inflation
without any employment benefits. The first institutional solution, investigated
by Rogoff (I985), is the appointment of independent inflation-averse central
bankers. If wage setters know that monetary policy is in the hands of an
independent anti-inflationary monetary authority, then their expectations will
reflect this. As a result inflation will remain low. This solution has an almost
perfect analogue in fixed exchange rate regimes (Giavazzi and Giovannini,
* We have benefited from the comments and suggestions of two anonymous referees and participants in
a seminar at Birkbeck. We would also like to thank the ESRC for financial support under the programme
on 'The Macroeconomics of Imperfect Product and Labour Markets' at Birkbeck. Alogoskoufiswould also
like to acknowledge financial assistance from the CEPR programme in International Macroeconomics,
supported from the Ford Foundation, the Sloan Foundation, and the SPES Programme of the EC
Commission. Ben Lockwood would also like to acknowledge financial support from the Leverhume Trust.
1 This is because in election years, inflationary expectations are a weighted average of the expectations
under the 'conservatives' and the 'socialists', the weights being the respective probabilities of election
victory. See below for further elaboration of this point. Surveys of recent theories of the interaction between
macroeconomics and politics can be found in Alesina and Tabellini (I988), Alesina (I988) and Persson and
Tabellini(I990).
I1370
]
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I992]
ELECTORAL
UNCERTAINTY
AND
INFLATION
I37I
I987; Giavazzi and Pagano, I988). Participation in such a regime, in which
monetary policy is determined by an anti-inflationary foreign central bank,
'ties the hands' of domestic policymakers, who cannot determine their
monetary policy independently. Again, this is reflected in the expectations of
domestic wage setters, and thus the domestic economy ends up with the same
average inflation as the rest of the economies participating in the system.
The present paper attempts two things. First, it generalises the partisan
model to allow for unemployment persistence. This extension is non-trivial
because if unemployment persists, any reduction in unemployment will have
future as well as current benefits for the party in power. Then, the time-horizon
of the government, i.e. the time to the next election, will affect its incentives to
create unanticipated inflation. It seems important to investigate this extension
as unemployment persistence is a generalised feature of OECD economies
(Bean et al., I986; Blanchard and Summers, I986; Alogoskoufis and Manning,
I988a, b).
Second, we investigate empirically the applicability of this 'extended'
partisan model, and the related fixed-exchange-rate-regime model, to the postwar experience of the United Kingdom. The United Kingdom is particularly
suitable for such an investigation as it is perceived to have had a rather
polarised political system in the post-war period. In addition, it has had long
experiences with both fixed and independently managed exchange rates. The
ideological differences between the Conservative and the Labour Parties have
been considered rather sharp, and both parties have held office for extended
periods. Thus, the United Kingdom makes an ideal candidate for testing the
implications of the partisan approach to inflation and the solution of entering
a fixed exchange rate regime.
The way we analyse these issues is to assume that wage setters set nominal
wages for one period (in our case a year) in advance, in order to achieve an
employment target (Gray, I976; Fischer, I977). We depart from Alesina
(I987) and Rogoff (I985), in that we assume that this employment target is a
combination of last period's employed (the 'insiders') and the unemployed (the
'outsiders'), as suggested by recent 'insider-outsider' theories (Blanchard and
Summers, I986; Lindbeck and Snower, i986).2 Because of the dependence of
the wage setters' target on last period's unemployed, changes in unemployment
persist, and the unemployment rate only gradually returns to its equilibrium
rate.3
This extension is analytically important, as it transforms the optimisation
problem of governments into a genuinely dynamic one. The government knows
that if it manages to reduce current unemployment, this reduction in
unemployment will persist in the future. Thus, in deciding whether to inflate
or not, they take into account the possible benefits from a reduction in
2 Models of this variety, however, cannot explain the outward shift of the European Beveridge curve, since
they do not distinguish between the long-term and short-term unemployed. As a result, they do not show how
the search behaviour of the unemployed outsiders may affect unemployment persistence.
3 Alesina and Rogoff implicitly assume that the wage-settler's employment target is fixed and less than the
government's target.
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unemployment not only in the present, but in the future as well. This means
that the incentives of political parties to create inflation differ according to
whether they are near the beginning or the end of their term of office.
We demonstrate two main results: First, if the 'socialists' care more about
unemployment than the 'conservatives', they generate higher inflation at any
point in their term of office. This is a generalisation of the basic Alesina (I987)
result for the dynamic case. Our second main result is that, if the preferences
of political parties for inflation and unemployment are close enough, inflation
will be higher for both parties in the period following an election (which we call
an election period) than in non-election periods. This latter result is very
different from the case without unemployment persistence examined by
Alesina (i 987) and Alesina and Sachs (i 988). In these papers, if the preferences
of parties are the same, inflation will be the same in non-election and election
periods. In our case inflation is higher in election periods because the
persistence in the reduction in unemployment by unanticipated inflation will
entail higher expected future benefits for the government near the beginning of
its term of office than one near the end. As this is anticipated by wage setters,
inflationary expectations are higher in the first part of a government's term.
We test this model for the British economy for the period between I952-90,
allowing for separate effects under fixed and managed exchange rates. The tests
are based on structural wage equations. To the extent that we concentrate
directly on structural wage equations, we provide an alternative to the reduced
form testing strategy of Alesina and Sachs (i988) and Alesina and Roubini
(I990).
Our first empirical finding is that the exchange rate regime matters
greatly for expected price inflation and hence nominal wage growth. One
cannot reject the hypothesis that expected price inflation in the Bretton Woods
period of fixed exchange rates has been independent of unemployment, the
party in power and the timing of elections. In addition, in the post-Bretton
Woods regime of managed exchange rates, a regime that has restored monetary
sovereignty to UK governments, expected inflation has been both higher and
more persistent, as it seems to have depended positively on the unemployment
rate. This positive dependence of expected inflation on the lagged unemployment rate, due to the Barro-Gordon effect, fully offsets the traditional
'Phillips Curve-type' negative dependence of wage inflation on lagged
unemployment.
Our second empirical finding is that even in the post-Bretton Woods regime
of managed exchange rates, there are very small differences between Labour
and Conservative administrations in non-election years. The parties have been
perceived to have the same incentives to create unanticipated inflation in order
to reduce unemployment. On the other hand, elections are associated with
higher expected inflation for both of them, as our theoretical model predicts,
but Labour administrations seem to be slightly more inflationary in such
periods.
However, differences between Labour and the 'pre-Thatcher' Conservatives
are not statistically significant. When we allow for the governments of Mrs
Thatcher to constitute a different regime, we find the following additional
I992]
ELECTORAL
UNCERTAINTY
AND
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I373
results: First, that there are no significant differences in expected inflation
between Labour and pre-Thatcher Conservative governments, either in nonelection or in election years. As predicted by our model, immediate postelection years are associated with significantly higher inflation than nonelection ones. Our second finding, however, is that there is no separate effect
of elections under the Thatcher governments. Yet, in non-election years these
governments have been associated with as high and persistent inflationary
expectations as the pre-Thatcher ones, Conservative and Labour alike.
According to these findings, the anti-inflationary contribution of the Thatcher
regime consisted in eliminating the electoral cycle in inflation that was
pervasive-after the collapse of the Bretton Woods regime of fixed exchange
rates.
In conclusion, the results suggest strong support for the exchange-rateregime model of inflation, and our dynamic-partisan model. Under managed
floating, expected price inflation and nominal wage growth were higher and
more persistent than under Bretton Woods. They did not depend on the
identity of the party in power, but, with the exception of the Thatcher
governments, only on the point in the electoral cycle. Between i968 and i979
they were higher in immediate post-election periods, and lower before
elections. After I979 they have been independent of the electoral cycle.
The rest of the paper is as follows: Section I presents the theoretical model.
This generalises the rational-partisan model of Alesina (I987), to allow
unemployment persistence to affect the optimal choice of inflation rates by
governments. It also draws on the exchange-rate-regime model of Giavazzi and
Giovannini (I987). Section II presents econometric tests for the UK economy
and the results are summarised and discussed in the final Section III.
I.
THE
MODEL
The main purpose of this section is to generalise the rational-partisan theory of
Alesina (i 987), to allow for the effects of unemployment persistence. We then
combine this dynamic rational-partisan-theory
with the Giavazzi and
Giovannini (i987) fixed-exchange-rates version of the conservative-central-
banker theory of Rogoff (I985)
.'
We assume that there are two types of agent, wage-setters and political
parties. Of the latter, there are two:' 'Labour' and 'Conservative'. Wagesetters unilaterally choose the nominal wage every time period, and, under
managed exchange rates, the party in power controls monetary (or exchange
rate) policy to determine the inflation rate. None of the parties can pre-commit
to low inflation under managed floating.6 The two parties may differ in their
4 The alternative approach to political business cycles views politicians as solely office motivated so that
they engineer pre-election booms to boost their electoral chances. See Rogoff and Sibert (1988). For a survey
of the political business cycles literature, see Alesina (I988) and Persson and Tabellini (I990).
5 This seems a reasonable assumption for the United Kingdom: although there are of course other political
parties, none of them has had a serious chance of forming a government in the post-war period.
6 Officially this is a floating and not a managed floating regime. However, in practice, pure floating has
operated infrequently and for short periods, as the authorities in most cases seemed to be pursuing some form
of exchange rate target through monetary policy.
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Election
I
-I|
I
t
Policy set
Policy set
Policy set
~~
~~~~~~~~~t
;
t
Wage
Wage
Wage
set
set
set
(non-election
year)
(election
year)
Fig.
i.
w
oTime
(non-election
year)
The timing of events.
relative evaluation of unemployment and inflation: Labour are systematically
at least as averse to unemployment as the Conservatives. Under fixed exchange
rates, monetary policy and inflation are determined abroad, either in a
cooperative fashion, or by a foreign central bank that acts as a leader in the
system.7
The timing of events is as shown in Fig. i above. Time is divided up into
discrete periods, or years. Wage setters sign annual nominal wage contracts at
the beginning of each year, before monetary and exchange rate policy are
chosen for that year. We suppose for simplicity that elections take place every
second year (but none of the qualitative results below are sensitive to this
assumption), and that the election takes place after wages have been set for that
year. Thus, in election years nominal wage contracts are signed before the
outcome of the election becomes known. In non-election years there is no such
electoral uncertainty. Finally, the probability of any party being elected, q, is
assumed to be independent of the government's choice of monetary and fiscal
policy, although we initially allow q to depend both on the identities of the
parties and the identity of the incumbent.8
Wage-setters know the exchange rate regime, and the identity and
preferences of the incumbent party. They take this information into account in
forming their expectations. They aim9 to achieve an employment target that
depends asymmetrically on those who have been employed in the previous
period ('insiders') and those who have been unemployed ('outsiders'). Finally,
employment is determined by competitive firms.
7 Here we implicitly assume that the costs of abandoning an international agreement, like a fixed
exchange rates regime, make the commitment to low inflation more credible than the unilateral fixing of the
exchange rate, or other domestic commitments to non-inflationary monetary policy. Also, it is now widely
accepted that fixed exchange rate regimes operate asymmetrically (see Eichengreen, I985, I989; Giavazzi
and Giovannini, I987; Giovannini, I989 and others). For example during the classical gold standard
(I890-I9I4)
the Bank of England was to a large extent determining the aggregate stance of monetary policy,
while a similar role was played by the Fed in the heyday of Bretton Woods, and is played by the Bundesbank
in the EMS. In addition there is now considerable evidence that such fixed exchange rate regimes have been
successful in containing average inflation and inflation differentials (see Alogoskoufis and Smith, I991;
Alogoskoufis, I992).
8 The exogeneity of q to policy is a standard assumption in the RPT literature, and can be justified by
rational expectations on the part of the private sector; with such rational expectations, electoral 'bribes' will
be discounted fully and hence have no effect on q. We also assume, for simplicity, that the timing of elections
is exogenous.
9 See Blanchard and Fischer, I989; Chapter 9, for more complicated objective functions of wage setters.
I992]
ELECTORAL
UNCERTAINTY
AND
INFLATION
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I. i. Wage and EmploymentDetermination
At time t demand for labour, ld, is a decreasing function of real wages (all
variables, with the exception of the unemployment rate will be in logs):
ld
6 (Wt _Pt _AIt) n(
where, e is the elasticity of labour demand, wt is the nominal wage, Pt the price
level, and Jutis a productivity shock. The growth rate of the productivity shock
is equal to g.
Following Blanchard and Summers (I986); Lindbeck and Snower (I986)
and Alogoskoufis and Manning (I 988 a), we assume that nominal wages are set
by 'insiders', who aim to achieve an employment target lt. This is a weighted
average of the labour force n, and those who are employed at the time the
contract is being drawn up, It-,. Thus,
It = Alt-,+
(i-A)
n;
o
A
I,
(2)
where A measures the extent to which the unemployed are disenfranchised from
the labour market.10
Nominal wage contracts are signed at the beginning of each period so as to
make the expected demand for labour (i), equal to the employment target of
wage-setters (2). If the information set of wage-setters includes all values up to
and including period t- i, then nominal wages are given by
wt = g + lit1 + Et-lpt-
I -A
A
n-e -It-1'
(3)
where Et_1 denotes a mathematical (rational) expectation conditional on the
information set available at the end of t- i. Lagging (i) once, solving for IAtand substituting the solution in (3), after some rearrangement, we end up with,
= g+Et_1ApAXwt
p -
ut-1,
(4)
where A is the first-difference operator, and ut-, is the lagged unemployment
rate, defined as ut1_ n-it-1, where n is the log of the total labour force.
Equation (4) defines the expectations augmented 'Phillips curve' in this
model."l
Ex post, employment is determined by labour demand (i). Using (i), (2) and
(4), unemployment is given by,
ut = Aut_1- e(Apt-EEt- Apt).
(5)
10 If A equals one, only the employed (insiders) matter for wage setting. If A equals zero both the employed
and the unemployed get the same weight (Blanchard and Summers, I986).
" To avoid the theoretical possibility of negative unemployment, one could define n to be the labour force
corrected for some measure of frictional unemployment. The analysis that follows would not change, the only
difference being a slight change in the definition of the state variables. Such an amendment would, however,
require the use of a particular model of the frictional unemployment rate, and in the interests of economy
we have decided to stick to the definition in the text, which is equivalent to assuming a constant frictional
unemployment rate.
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[NOVEMBER
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From (5), unanticipated inflation reduces unemployment, and the higher is A,
the higher the persistence of this reduction."2
1.2.
Inflation, Unemploymentand Political Parties
We assume that both the Conservative party (denoted by the superscript c) and
the Labour party (denoted by the superscript 1) prefer full employment and low
inflation. In particular, when in power, the loss from unemployment and
inflation to party i = c, I in period t is,
Gi=(,pt
-,Apt
)+
a ut;
aC
al.
(6)
When out of power, the payoff to any party is zero. Note from (6) that the
parties may differ only in their degree of aversion to unemployment. In what
follows we allow the target level of inflation to depend linearly on the lagged
domestic inflation rate.
I > 0 > o.
(7)
?+ Pt-,;
In (7) we assume that the target inflation rate of the authorities depends
positively on past inflation, as the higher the inherited inflation rate, the more
costly the policy adjustment required to reduce it to an arbitrarily low level 7T0.
Thus, governments are allowed to modify their target rate to take account of
these costs. 0 is an indicator of the cost of adjustment of policy.
Under a managed exchange rate regime, the party in power chooses current
and future inflation to minimise the discounted expected present value of losses
(6). We assume fully rational behaviour, in that each party takes into account
the probability of losing (and subsequently regaining) power in election years.
From (5) above, current unanticipated inflation affects future unemployment. Also, from (7) above, current inflation affects future inflation
targets. Thus, the model has structural dynamics, unlike the theoretical models
of Alesina (I987) and Alesina and Sachs (I988), who add lags only at the
empirical stage. Our dynamic approach is preferable for at least two reasons.
First, it is more realistic. Empirically, unemployment (and inflation under
flexible exchange rates) is highly serially correlated. As we shall see below,
unemployment dynamics imply that in the absence of pre-commitment, the
optimal current policy of the government will depend on the 'state variables'
of lagged unemployment and lagged inflation. Thus, the theoretical model will
produce dynamic econometric equations directly, and there will be no need to
add on extra dynamics at the estimating stage. Second, and equally
importantly, the inclusion of unemployment dynamics changes some of the
qualitative predictions of the RPT model.
APt
1.3. A Dynamic Game betweenWage-Settersand Political Parties
Because of the structural dynamics, it is convenient to interpret the model as
a dynamic game, with three players, the two parties and the wage-setters (see
Basar and Olsder, I982, for a general discussion of dynamic games). The party
in power chooses Apt, and wage-setters 'choose' Et-, Apt. For wage setters,
12 In the extreme case when A = i, the unemployment rate stays at the new lower level until a new shock
displaces it again. In other words, it displays 'hysteresis'.
ELECTORAL
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UNCERTAINTY
AND
INFLATION
I377
forming rational expectations is then equivalent to minimising a loss function
W = (Apt-Et-, Apt) 2.13
It appears at first sight that, at time t, we have two state variables, ut-1 and
Apt-1.However, we can define
(8)
APt-,
i t = Et-1 APt- To-A0 pt-,
where 7i denotes the expected deviation of inflation from the target of the
authorities.
Substituting (8) in (6), the players' one period loss functions can be written
as a function of current variables only: Gi = (7Tc)2?oxiut,and W = (gT-7T1)2.
So, the problem is re-formulated into one with only one state variable, ut-1,
whose change is described by the state equation from (5).
gt = APt-7TO-0
(s')
(-t
t),
To complete the description of the game, we must specify the exogenous reelection probabilities. One possibility is to assume that these probabilities are
for Labour, where q' is independent of
qG for the Conservatives, and q' = I the past history of the game. This is the assumption made in Alesina (i 987) . We
call this the partisan advantage version of the model, as some party has an
advantage over the other due to its general characteristics. However,
independence of past history is a strong restriction, as incumbents have a
number of advantages, so q mi-ght be higher for incumbents of either party.14
An alternative, therefore, is to assume that the qs are independent of party
identity, but higher for the incumbent, so that I > q > 0o5 is the probability of
re-election of the incumbent. We call this the incumbencyadvantageversion of the
model. The two models are nested in a more general model in which election
probabilities depend on both incumbency and the identity of parties. The
incumbency model is somewhat easier to analyse, and so we concentrate on this
model below. The analysis of the partisan advantage version of the model is in
u= Aut_1
-
qC
Appendix
i.
It turns out that the empirical predictions of the incumbency advantage
model are slightly more general than those of the partisan advantage version:
we are thus able to test the additional restrictions of the latter on the data. We
also present a direct test of the validity of the two processes for q against a more
general process where q can depend on both the party identity and incumbent
identity. The details of this test are in Appendix 2, and the results suggest that,
given the election results in the United Kingdom since I952, the two special
models have the same likelihood and cannot be rejected against the more
general model where election probabilities depend on both partisan characteristics and incumbency.15
13 Lockwood and Philippopoulos (I99I)
investigate a dynamic game between insiders and a single
monetary authority, while Alogoskoufis and Philippopoulos (i 99I ) combine a static partisan model with an
exchange rate regime model and investigate its applicability to Greece.
14 For example in the United Kingdom, the incumbent party has the option to choose the date of the
next election within the constraint that the period between elections does not exceed five years. The fact that
historically, the gap between elections has typically been significantly less than five years testifiesto the value
of this option.
1 For the unrestrictedmodel, the estimated probability of a Conservativevictory when the Conservatives
are the incumbent is equal to 67 % and the estimated probability of a Labour victory when Labour is the
48
ECS 102
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1.4. PoliticalEquilibrium
We shall define political equilibrium to be a Nash equilibrium to the game
described above, where the actions of the players depend only on the current
value of the state variable. This is known as a Markov-perfect(Fudenberg and
Tirole, i99i) or feedback Nash (Basar and Olsder, I982) equilibrium. The
imposition of this restriction on the equilibrium rules out equilibria based on
'punishment' strategies as in Barro and Gordon (I983b). As the model is
linear-quadratic, we may suppose that the actions of the players are linear
functions of the state variables, i.e.
=
7t
g,
t-1;
e, n; 7Tt= 7TUt-1
I=C) ilj
(9)
where, e and n stand for election and non-election years, respectively.
To characterise equilibrium inflation in this setting, note first that optimal
behaviour for the wage-setters (i.e. rational expectations) is to set 1Tt= 7. From
(g) this implies that,
7
=
7(i)
=
n
(non-election year with incumbent i),
qT?+ (i -q)
7Ti (election
year with incumbent i).
(ioa)
(iob)
Now we turn to the equilibrium behaviour of the political parties. Again
because of the linear-quadratic structure of the model, we can write the
discounted present value of losses from unemployment and inflation from time
t onwards as a quadratic function of the unemployment rate inherited from
t- , i.e.
i = c, 1, j = e, n, where /?'> o is an, as yet, undetermined
1
u2_/2,
coefficient. Note that /J?depends on the time to go to an election but not on
calendar time.
The f, and the associated inflation rates 7T, must satisfy the following
recursion equations:
U
=
min [(ir ut_)2+ (x1?&/3n) u2]
(election year),
(IIa)
e
,n u_1
=
min [(iT
u_1) 2 + (c? +
q6/e) u2] (non-election year),
(II
b)
'Tn
where in both cases the minimisation is subject to (5') and (9), with the wagesetters expectations Tt taken as exogenously given. These require the present
value of losses at time t (the left-hand sides of (i i a) and (i i b)) to be equal to
the sum of the current loss and the expected value of future losses from t+ i
onwards, when current inflation is chosen to minimise this sum (the right-hand
sides of (iia) and (iib)).16
incumbent is equal to 50 %. For the incumbency advantage model the estimated probability of a victory for
the incumbent is 6b0%. For the partisan advantage model, the estimated probability of a Conservative
victory is 60 %,
16 One of our referees has objected strongly to our assumption that the parties do not care at all about
inflation and unemployment when out of power. He finds the assumption unreasonable in the context of pure
partisan models, pointing out that the Alesina model does not make this assumption. This is true, but
whether one uses this assumption or not in the Alesina model does not matter, as this model contains no state
I992]
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We can now solve (i i a) and (i i b) in several stages. First, calculating the
optimal inflation rates from (ii a) and (ii b) conditional on fixed /7T, , and
substituting in the equilibrium conditions (ioa) and (iob), we find that the 7rT
are;
lT =yA
(I 2a)
-d
-e?(i)
ie Ji=
+
d
=
(if incumbent i wins),
i
(I2b)
(if non-incumbent i wins),
(12C)
where
d= = q
+
y?
(I - eq)
j * i)
y'
=
e[x + 8q1e(i)],
=
e((x?+
)
Note that the value of 7Te depends on who the incumbent party was; we have
written 7T(j) for the inflation rate in election year when party i wins the
election from partyj. For the same reason, the Pe also depend onj, so we have
written fli(j) to express this dependence. Note, however, that the /?n do not
depend on the identity of the previous incumbent; this is clear from (ii a),
where the right-hand side only depends on parameters u,-1, q, 86,a , and fle(i)
and 7Tare independent of the identity of the previous incumbent from (io a).
We then say that the six pairs 7T4U),fe(), ' i, l-, i,j = c, 1, are a political
equilibriumif they solve (i i a, b); (i 2 a-c). The equilibrium inflation rates can
then be solved recursively. Substituting (I2 a, b) back into (ii a, b), and
equating coefficients on u,-1, yields two pairs of simultaneous quadratics in
coefficients (/fe (i), fnl), i = c, 1,known as Riccati equations in the dynamic game
literature. In general, these Riccati equations can have unique, multiple or no
solutions. Substituting solution values of fle(i), /?n,i = c, 1 (if they exist) back
into (I 2 a-c) gives the equilibrium inflation rates in terms of the parameters.17
1.5. Inflation,ElectionsandPoliticalParties
In this section, we investigate how inflation varies with the party in power and
the time to the next election. In establishing these comparative statics results,
we face the problem raised above, namely that there may be no, or multiple,
political equilibria. Therefore, we focus attention on a particular equilibrium,
the limit equilibrium,which can be shown to exist as long as 8.A2 is low enough.
The limit equilibrium is the equilibrium whose inflation rates and valuation
coefficients are limits of those of the finite horizon version of the game as the
time-horizon becomes infinitely long. This is a rather attractive equilibrium
to study, as the results obtained are robust to the introduction of a finite
horizon.
variables.In our case, however,the qualitativenature of our resultsis not affectedif one generalises
somewhatby simplyassumingthatpartiescaresufficiently
lessaboutinflationandunemployment
whenout
of powerthanwhenin power.Thus,ourmodelcan be seenas a combinationof a purepartisanmodelwith
an 'opportunistic'model,whenpartiescannotaffecttheirre-electionprobabilities
througheconomicpolicy.
17 It is then possibleto solvefor/e(1), flA(c)
by substitutingbackinto (i I a), but we are not interestedin
,/Ie(l),/?e(c)as they do not affectthe Yland thereforedo not determinethe inflationrates.
I380
THE
PROPOSITION i.
JOURNAL
ECONOMIC
[NOVEMBER
A limit equilibriumalways exists if &A2is small enough.In the limit
if acl> oci 7T1(i)
equilibrium,
> 7Tc(i), 7nT > 7nT, i.e.
inflationis higherin non-election
years if Labour is the party in power, and also in electionyears, conditionalon a given
incumbent.
Proof. See Appendix 3.
Proposition I asserts that the predictions of the static RPT - namely, that the
more unemployment-averse party will inflate more in every period than the less
inflation averse party - carry over to the dynamic incumbency advantage
model.
We now focus on inflation in election years. In our empirical work, we
are not concerned with inflation per se, but only in the wage-setter's expectations of inflation in election years, which is a weighted average of the two
party's inflation rates and so depends only on the previous incumbent,
and
i.e. T(l) = q7T(l) + (i -q) 7nc(l) if Labour was the incumbent,
then
We
incumbent.
the
were
if
Conservatives
=
7T1(c)
q)
AT(c) q7T(c) + (i
have:
iT(l) > ii(c), i.e. expected
PROPOSITION2. If cc'> occ and q > o
inflationin election
years is higher if Labour was the previous incumbent.
Proof. From
(I 2 a-I 2 c) and
proof of Proposition
I,
the definition of di, AT(i) = Ad,/ (i -di). From the
which implies I > d, > dC so the result
y/ > yce
follows. I
Finally, we turn to the question of how inflation varies over the term of office
for a particular party. We start with a 'benchmark' result:
= o, 7T(i) > nT,71(i) < 7Tni = c, 1,
PROPOSITION 3. With myopicpreferences,i.e. 8
i.e. whoeverthe previous incumbent,inflation is higher in the post-electionperiod for
Conservativegovernments,but the reverseis truefor Labourgovernments.
= cci, so this follows immediately from
Proof. If 8 = o,
I
(I 2 a-c).
The intuition for this is as follows: when the Conservative (Labour) party is in
a post-election year, wage settlements have been based on a higher (lower)
expected rate of inflation than in a non-election year. Thus, taking these
expectations as fixed, to achieve a given reduction in unemployment, they must
inflate more (less) than in a non-election year. Thus, even in the static RPT
model, inflation does vary over the electoral cycle. (This point has been made
by Alesina and Sachs (I988), p. 70.)
This can be contrasted with the following result:
PROPOSITION 4. If acc= acc,then7Te > Tn) i = C)1. Inflationis higherforbothparties in
the periodfollowing an electionthan beforean election.
Proof Let acc=
cc
= c. Then from (I 2 a-c),
7Tn =
e(aC + q8l/e), n7e
(
/3n)
q/Jn which
implies f/n < fle, as q < i. But then after substituting for inflation into the
recursion equations, this implies
Now suppose on the contrary that ne
e2(X +q&l3e)2+ (cc+qq/3e) A2 =/fn
< 7n.
< fie
=
This requires f/3n
62(cX?+8y3 )2? (cc+8ykn)
A2
I992]
ELECTORAL
UNCERTAINTY
AND
INFLATION
But this inequality implies that q/3, </3n, a contradiction.
I38I
I
The intuition for this result is as follows: As from (5') the incumbent party
faces a perceived negative tradeoff between inflation and current employment,
and there is a positive link between present and future employment, the party
in power will have a greater incentive to raise inflation, the more it cares about
the future. The closer it gets to an election, the less it cares about the future,
as the probability of losing office comes closer. This is clear from the recursion
equations above. A unit reduction in unemployment has a future return of &/?fn
just after an election (when the next election is two years away), and only q&/3le
when the election is one year closer.
Propositions 3 and 4 suggest that when 8 is high and ac'is close to aC, both
parties will inflate more immediately after elections than before, whereas when
8 is low and ac' is much larger than aC, the Labour party will behave in the
opposite way when in power. Thus, when the preferences of the parties over
inflation and unemployment are not too different, the effect identified in
Proposition 4 is large enough to more than offset the force, outlined in
Proposition 3 above, which lowers the post-election inflation rate for Labour
governments in an environment without forward-looking behaviour.
Analogues of Propositions I-4 for the partisan advantage version of the
model are established in Appendix i. Proposition 3 continues to hold, and so
do Propositions i and 4 if q' and qc are sufficiently close. However, Proposition
2 becomes rather different if incumbency has no effect on the election outcome.
7T(i) becomes independentof i.18
1.6. Inflationand Political Parties underFixed Exchange Rates
The next question that needs to be resolved is the determination of expected
inflation during fixed exchange rate regimes. In our sample, the only such
regime in which the United Kingdom participated was the Bretton Woods
system of fixed exchange rates. In this regime, UK administrations did not
have the independence of determining the average domestic inflation rate. Up
until I968, the average OECD inflation rate was determined by the monetary
policy of the Federal Reserve System. Under the rules of Bretton Woods all
countries with the exception of the United States were pegging their exchange
rates to the US dollar, while the Fed undertook to maintain a fixed price of gold
at $35 an ounce. This precluded accommodation of price shocks by the Fed,
and resulted in lack of inflation persistence (see Alogoskoufis and Smith, I99I,
and Alogoskoufis, I 992). Thus, given the characteristics of this system we shall
assume that expected inflation in the United Kingdom during the Bretton
Woods system of fixed exchange rates was constant and, given the obligations
18 Our dynamic 'partisan model' implies a clear time pattern for inflation (see Proposition4):
policymakersgo for higher inflationimmediatelyafter electionsthan beforeelections.'Opportunistic
models'withsluggishpriceadjustmenthavea similarimplication,aspre-electoral
expansionary
policieslead
firstto lowerunemployment(beforethe election)and laterto an increasein inflation(afterelections).In
principle,one shouldbe able to distinguishbetweenthe two models,by usingunemploymentas well as
inflationequations.
I382
ECONOMIC
THE
[NOVEMBER
JOURNAL
of the Fed, lower than expected inflation under managed floating. Thus we
assume that,19
3)
Et-, Aptf = '7Ton('I
where, 7ro is a constant.
Participation in a fixed exchange rates regime in order to gain the antiinflationary credibility of a foreign monetary authority that determines
monetary policy for the whole system is the central hypothesis of Giavazzi and
Giovannini (I987) and Giavazzi and Pagano (I988). Their models are
applications to open economies of the Rogoff (I985) idea, that appointing an
independent, inflation-averse central banker will affect the inflationary
expectations of wage-setters, and will thus result in an equilibrium with low
inflation. In our model, the assumption is that this also does away with the
dependence of equilibrium inflation of past-unemployment, as it is highly
unlikely that the Fed took British unemployment into account in determining
its monetary policy.
We can now move on to empirical testing.
II. ECONOMETRIC
ESTIMATES
AND TESTS:
THE UNITED
KINGDOM
I952-90
In this section we present the econometric specification of the model and discuss
estimation and a number of testable hypotheses. Subsequently we discuss the
data and present econometric estimates and tests without and with allowance
for a separate Thatcher regime.
II.
I.
EconometricSpecification
and (ioa, b) and (I3) into (4) gives us estimable wage
Substituting (I2a-c)
equations for the incumbency advantage model. They can be written in
general form as
=g+rTO+
/t
g + 7TO+ OA\pt-1
/\Wm
AW+Of
I
Ut-,+PnUt-,
OApt-i
6ut-1
+)
= g U++7TO-
Pe
lt-1
ct-1)
(i
=
i
c,l),
(I4a)
4 b)
c l
(
(I4C)
where i is an index of the government in power, j an index of the incumbent
in an election, and the ps satisfy (see (i o a, b) and (I 2 a-c)),
= 4;
Pn4~
(i = c, 1),pe = qi4(j) + (i -q)
7Te(j); i,j =
c,
lij.
( )
Equation (I4a) refers to wage inflation under a managed exchange rate
19 Equation (i8) iS probably too restrictive, as under Bretton Woods governments could have inflation
rates that were temporarily different from American rates, but not persistently different. Allowing for
temporary differences in inflation rates would not affect the nature of our results.
I992]
ELECTORAL
AND
UNCERTAINTY
INFLATION
I383
regime, in a non-election year, when party i is in power. Equation (I 4 b) refers
to wage inflation under a managed exchange rate regime in the aftermath of
an uncertain election, where the incumbent was party j. Equation (I 4 c)
refers to wage inflation under the fixed exchange rate regime of Bretton
Woods.20
Estimation of the model is straightforward. Since all the right-hand-side
variables are lagged, OLS is consistent. To allow for the differences under
alternative regimes one can estimate a single wage equation with multiplicative
dummy variables to capture the regime shifts.
Given Propositions I and 2 in section I, we have the following predictions on
the ps for the incumbency advantage model:
1C 1Pn
P
(i6a,
P
b)
For the partisan advantage model, we have the additional restriction that,
(I7)
Pec= pe.
Equation (I 7) reflects the property that if the probability of election is party
specific, expected inflation will not depend on the identity of the incumbent, as
it will be a simple weighted average of expected inflation under either party
(Proposition A2). So, the main difference between the partisan advantage and
incumbency advantage models is that for the latter, the coefficient on ut_1 in
(i 6 b) should be higher (lower) if the Labour (Conservative) party was the
incumbent party at the election, whereas for the former, the two should be the
same.
It is also worth considering the additional predictions of the model in the
special case where there are no differences between the two parties in their
relative aversion to unemployment (similar preferences). In that case, if we
assume the incumbency advantage model, from Proposition 4, the relevant
restrictions will be,
Pn =Pn
= 7Tnh Pe = Pe = 7Te
Te > 7Tn.
(I8a-c)
Equations (i8a, b) suggest that there are no party-specific differences in
expected inflation in either non-election or election years. Equation (i 8 c)
reflects our Proposition 4, that, because of the longer horizon of an election
winner, the present value of reductions in current unemployment through
unanticipated inflation is higher, and expected inflation rises to reflect that.
These predictions are also generated by the partisan advantage model in the
case where qc = ql = o05.
20 While the theoretical model examines two periods (election and non-election), in fact an election period
is followed by up to four non-election periods. A correct specification would therefore affect the values of the
ps (depending on how many periods are left before the next election). However, this would not change our
qualitative results since electoral uncertainty exists only in the election period.
I384
11.2.
THE
ECONOMIC
JOURNAL
[NOVEMBER
The Data
Before we move on to estimation and testing, a brief presentation and
discussion of the data is in place. Fig. 2 depicts wage and consumer price
030 -
002s
20 - ............................
015-
0:10
0.05.-
''....................
''''''''''''
.
Wag in,aiio n
-4...........
/
o.oo -
2.
,
-~~~~~~~
/
~~~~Price
rate
Unemployment
inflation
1965
1960
1970
1975
1980
1985
Wage and price inflation and the unemployment rate.
1955
Fig.
1;C&
1990
inflation and the unemployment
rate in the United Kingdom from I952 tO
I 99O. The wage series (hourly earnings in manufacturing, I 985 = i), the price
series (the Retail Price Index, I985 = i) and the unemployment rate are from
various issues of Economic Trends.
The basic dummy variables used are reported in Table i. In constructing the
dummy variables for exchange rate regimes we assumed that sterling was
expected by wage setters to remain fixed to the dollar until the devaluation of
sterling in November I967. Thus, in our empirical work we assume that the
Bretton Woods system credibly applied only between I952 and i967. In any
case the anti-inflationary credibility of the system was undermined in the late
i96os not only by the devaluation of sterling, but also by the abandonment of
the gold pool and the establishment of two-tier gold arrangements on I6-I 7th
March, I968 (see Solomon, I982) 21
In constructing the party political and post-election dummies we divided
particular years according to the proportion of total quarters in a year that
each party spent in power, and the proportion that belonged to immediate
post-election year (see note to Table i). We only used information relating to
the quarter of the year in which an election was held, as the exact timing of an
election in the United Kingdom is usually not known sufficiently in advance to
justify finer distinctions.22
21
In any case, our empirical results are not particularly sensitive to the exact choice of year for the
abandonment of Bretton Woods.
22
We have toyed with the idea of using quarterly rather than annual data. We have eventually rejected
it, against the usual argument that we would have more degrees of freedom, on the following grounds: First,
the increase in degrees of freedom would have been apparent rather than real, since the episodes that matter
for our purposes are elections, and using quarterly data does not give more of these. Second, the United
Kingdom is characterised by an annual wage round, so a year is the natural time period. Third, quarterly
observations generate additional statistical problems, related to the question of seasonality and spurious
ELECTORAL
I992]
UNCERTAINTY
AND
I385
INFLATION
Table I
Dummy Variables Used in the Regressions
I 952
I 953
1954
I955
I956
1957
1958
a5
d
I
I
I
I
0
0
0
0
0
0
0-875
0
0
0
0
0
o0I25
0
I
I
0
0
0
0
0
o625
0 375
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0375
o-625
I
I
0
0-I25
0
0
0-875
0
o875
0
0
0
0
0
01I25
0
I
0
0
I
dedc
del
dnc
dnt
d0il
1959
I
I
I
I960
I
I96I
I
0
0
I 962
I
0
0
0
0
I
I 963
I 964
I 965
I
I
I
0
0
0
0
0
I
0
0-I25
0
0
0-875
0
I966
I
I967
I 968
I 969
I
0
0
0
0
0
0
o-875
0
0-I25
0
0
o-625
0?375
0
0
0
0
0
I
I
o-625
0?375
0
0
0
0
0
I
0
0
0?375
0
0
0
I
I
I
0
0
0
0-375
0
0
0
0
0
o-875
0
0
0
0
o-625
I
I
o0I25
0
0o875
01I25
0
I
0
0
0
0
0
0
0
I
I
I
o0625
0 375
0
0
0
0
0
0
0
0
0
0
o-625
I
I
0
I
I
I970
I97I
I972
0
0
1973
0
I974
0
0
I
0
0
I
I
I
I975
1976
I 977
I 978
1979
I 980
0
0
0
I
I
o-625
0
0?375
0
0
0
I
I98I
0
0
I
0
0
I 982
0
I
0
0
0
I
0
I983
I984
0
I
0
0
I
0
0
0
0
0
0
0o375
o-625
I
I
0
0
0
0
0
o-625
0 375
0
0
0
0
0
0
I 985
I986
I987
I988
I 989
I 990
I
I
I
0
0
I
I
o-625
0 375
0
0
I
0
0
0
0
0
0o375
o-625
I
0
I
0
0
0
0
0
0
0
Notes: adf denotes the Bretton Woods system of fixed exchange
rates before the devaluation
of sterling in
I 967, and d' Bretton Woods after the devaluation of sterling and the post-Bretton Woods managed floating
regime. deCand de' denote the proportion of the year that fell within the four quarters immediately after an
in which
the incumbent
election
was the conservatives
and labour
dn' and dfc denote
respectively.
of the year under a Labour and a Conservative
the proportion
respectively
the
administration,
excluding
four post-election
quarters.
Finally d05'denotes a zero-one
dummy variable for the oil shocks.
II.3. Estimates and Testsfrom Wage Equations, 1952-90
In Table 2 we present evidence relating to the wage equations in (I4a-c). We
start with a fairly unrestricted wage equation, which is reported in column I.
In this we allow for separate dummy variables for each political party, for each
exchange rate regime, and for election and non-election years. Thus we have
dynamics. On balance, we therefore decided that the costs of using quarterly data would outweigh the
benefits. An additional investigation with quarterly data may be useful at a later stage, but it does not appear
to us that this is how one should start.
1386
THE
ECONOMIC
[NOVEMBER
JOURNAL
Table 2
WageInflation,Electionsand theExchangeRate RegimeEstimatesand Testsfor the
UnitedKingdom
(Dependent variable: Awt, sample:
Constant
APe-1
method of estimation: OLS.)
(I)
(II)
(III)
(IV)
oo96
0-094
0-93 I
0I
(O-OII)
(O-OI2)
(00-I 3)
Ap^t1
I952-90,
02
(0-0I 2)
-0-28I
I
(0o3I9)
?0403
(0'I07)
ut-l
-2.004
utf_l
1
(0-973)
-4 57I
0-4I
I
(00I 4)
0-322
(0-089)
-2-2I5
-2-277
(o-835)
0-3I9
(0-095)
-2.784
(o.853)
(o0876)
(2.938)
u-tf1
o-8og
(I'I 19)
a-tfe1
4-426
I38)
I.56i
(3
utm-1c
mnl
utm-11
um-elc
umMel
t-1
do"
(0-924)
I o036
(o-983)
I-8I4
(0o938)
3'430
(I-OIO)
0-052
(0-020)
I*847
(0-767)
I1323
(o-833)
I__8
(0-785)
i-_822
I838
(0-785)
2-2q4
(0-814)
2-24
(0-8I4)
2-099
2-o96
2-723
(0o783)
3'743
(o-802)
3-668
3'2
(o-8io)
2723
(o-837)
(o-85s)
(0-8 I0)
0-05 I
(0-020)
o0o63
o-o84
(00 I9)
(o-oi8)
R2
o-86 i
o-843
o-83 I
o-8o i
17
0-020
0-020
0-020
0-022
I-883
i-8i i
I-678
I-796
0-203
0-367
I*o83
0-496
i-i i6
0333
0455
DW
AR (i)
JB (2)
ARCH (i)
F-test
1-950
I-283
O1I84
2-495
o-8o5
(4,
27)
2-54I
(,
3I)
I-IOI
5-576
(I,
32)
Notes: Ayvand Apm denote the product of Ap and dummies df and dmrespectively. uijdenotes the product
of the unemployment rate and dummies with superscript i and j. Asymptotic standard errors are in
parentheses below estimated parameters. R2 is the coefficient of determination, o- the standard error of the
regression and DW the Durbin-Watson statistic. AR (i) is a Lagrange multiplier test for first-orderresidual
autocorrelation,JB (2) is the Jarque-Bera test of non-normality and ARCH (i) is a Lagrange multiplier test
for autoregressive conditional heteroskedasticity, based on an auxiliary regression of squared residuals on
their first lag. These are x2 tests. In each column the underlined or bold coefficients have been imposed to
be equal. The F-test (degrees of freedom are reported below them) tests the validity of the restrictions that
the estimates in each column imply for the estimates of the preceding column. For variable definitions see
Table I and the text.
multiplied the party political and election dummies by the exchange rate
regime dummies. We also allow for a non-zero inflation persistence during
Bretton Woods. We have included an additional dummy variable for the two
oil-shocks.
This equation has an impressive fit (recall that the dependent variable is a
rate or change), and there is no evidence of statistical misspecification in the
reported diagnostics. Thus, we can treat it as a reasonable encompassing
statistical model, against which we can test the predictions of our model.
From the estimates in column I one would not at conventional significance
I992]
ELECTORAL
UNCERTAINTY
AND
INFLATION
I387
levels be able to reject the hypothesis that during Bretton Woods lagged
inflation does not help predict price and, therefore, wage inflation. The
asymptotic t-ratio is o9go. A second hypothesis, that expected inflation during
Bretton Woods did not depend on the identity of the party in power, or
elections does not seem to be rejected either, as neither of the coefficients of Ufnl,
Ufec, Ufet seem to be statistically different from zero. These restrictions are
imposed and tested in column II. The relevant F-test is much lower than its
5 0 critical value. Thus, one would not be able to reject the hypothesis that
expected price inflation, and therefore wage inflation, during Bretton Woods
was the same independently of lagged inflation, the party in power, or
elections. However, it is also worth noting that Labour was in power only for
3 out of the i6 relevant years.
The results in columns (I) and (II) of Table 2 fail to provide evidence against
the exchange-rate-regime theories of inflation, as the additional lagged
unemployment coefficients under managed floating are strongly positive and
significant, as predicted by our theoretical model. Managed floating seems to
eliminate almost completely the negative dependence of wage inflation on
lagged unemployment prevalent in the Bretton Woods system of fixed
exchange rates. According to our model this is because of the anticipation by
wage-setters of the incentives of political parties to inflate. As we showed in
section I these incentives are a function of lagged unemployment.
We next move on to testing the predictions of the RPT. The estimates of
column (II) are based on the incumbency advantage electoral model. The
partisan advantage model implies the further restriction that the identity of the
incumbent should not matter for expected inflation after an election (equation
(I 7)). The Wald-test for this restriction in the estimates of column II is equal
It cannot be
3284. =
to 6's. This restriction is rejected at 500 as XO.95(')
rejected at i % though (%0.99(I) = 6 63). The two restrictions implied by the
assumption that the parties have the same preferences for inflation and
unemployment (equations (i8a) and (i8b)) yield a Wald statistic of 8-47.
These restrictions are rejected at 500 but not at i % (X%95(2) = 5-99,
X%.99(2)= 92I).
However, it appears from the estimates of column II that, during managed
floating, the differences between political parties have been very small in nonelection years. In column (III) we impose the restriction that the two political
parties are seen by wage setters to have the same incentives to create surprise
inflation in non-election years. The F-test for this restriction indicates a very
high likelihood that this restriction holds. However, according to our model, if
the two parties have the same preferences in non-election years, expectations of
inflation will be the same in election years as well.
In column (IV), we present estimates under this additional restriction. The
rejection of the joint restrictions implied by similar preferences seems to be due
to election years only. The F-test for the restriction of equality of expected
inflation for the two political parties in election years is equal to 5y8, against
a 95 0 critical value of F(I, 32) equal to 4-2. Thus, the restriction of equality
of coefficients in election years is rejected at 5 0. However, this restriction is not
rejected at I %, since F0.99(I, 32) = 7-5.
I388
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[NOVEMBER
When we impose the equality of post-election coefficients, as in column (IV),
our proposition 4 is borne out. Expected, and actual, inflation is higher in postelection years, as the positive reaction of inflation to lagged unemployment is
higher. The X2(i) Wald-test for the statistical significance of the difference
between the two coefficients is equal to 2-9. Thus, the difference between nonelection and election years is statistically significant only at I o %, but not at the
customary 5 / .
Overall, the results in Table 2 suggest that the exchange-rate-regime model
cannot be rejected, but the evidence on the dynamic rational-partisan model
is weaker. There are no party-related differences in inflationary expectations in
non-election years, inflationary expectations are higher in post-election years
but not by much, and there is a stronger post-election inflationary effect when
Labour is the incumbent. In the light of these results we move on to investigate
possible separate effects for the Thatcher administrations, which are widely
regarded to have been a change in political regime in themselves (see Buiter
and Miller (i 983)) .
11.4. The ThatcherRegime and UK Inflation
Did Mrs Thatcher make a difference for expected inflation in the United
Kingdom, and what was the nature of this difference? This has been a question
that has intrigued macroecoyiomists and political commentators in Britain and
abroad from early on. The estimates in Table 3 attempt to examine this
question in the context of our model.
Column (I) presents the unrestricted estimates of column II of Table 2 in a
different format. The superscripts mn and me refer to non-election and election
years during managed floating. The estimated coefficients of lagged unemployment for these periods measure the response to unemployment that was
common to all Conservative and Labour governments. Then, the coefficients
of variables with the additional superscript I measure the additional effect from
the Labour governments. One can directly see in Table 3 that there is no
statistically significant additional Labour effect in non-election years, but that
there is a large positive one in election years which is significant at 5 00.
Column II presents estimates with additional Thatcher dummies (Ig80-go).
The format is as in column I, the dummies with the additional superscript t
denoting differences of the Thatcher governments from the rest.
One notes immediately that the differences between pre-Thatcher conservatives and Labour in election years become statistically insignificant. Also,
there do not seem to be significant differences between Mrs Thatcher and the
rest in non-election years. These restrictions are imposed in column III and
cannot be rejected by the F-statistic at the conventional 5 0. In column IV we
also impose the restriction that the dependence of expected inflation on lagged
inflation was no different under Mrs Thatcher. This restriction cannot be
rejected either.
The estimates in column (III) suggest that there are no differences between
Labour, pre-Thatcher Conservatives and Thatcherite Conservatives in the
weighting of unemployment relative to inflation. All governments have been
perceived to care the same about unemployment, and, given past un-
ELECTORAL
I992]
UNCERTAINTY
I 389
INFLATION
AND
Table 3
Wage Inflationand the ThatcherRegime
(Dependent variable: Awt, sample:
APt-1
o-083
0o094
(O-OI
0'41 I
(O' I 04)
(o I I g)
-
umn
-I
-2277
(o0835)
I-847
?-523
(0-33
-252
)
526
(o 856)
1-288
(0-715)
-o-642
0'I04
ume1
mel
(0583)
420
4 202
2 099
umel
I *644
(o0645)
u1 -t
do"l
005 I
(0-020)
R2
o0843
CT
0-020
DW
I-8I I
0-367
AR (i)
JB (2)
ARCH (i)
F-test
I1283
0077
o0o83
o.o85
(O-OI I)
(O-OI I)
0-327
(oo8o)
(0-079)
0'312
(0-103)
-
I531
(0'791)
I-363
(0-712)
-
I679
(0o778)
I'425
(0-709)
(0?459)
ut-1
(0 784)
(IV)
_01I03
(0138)
(0o767)
u mnll
2)
0-47I
-
(III)
(O-O I I)
Apt-1
Ut_1
method of estimation: OLS.)
(II)
(I)
Constant
1952-90,
(*1.53)
-o 983
(II73)
-2-8I7
36
3-6I I376
(0o737)
--21I97
3-763
(0-72I)
-2242
(i *i 85)
o0o62
(o0o I 8)
(o-o65)
o-o65
(0-0 I 7)
0-059
(o o I 6)
o0894
o-871
o-867
O I7
o0oI8
ooI8
I-873
01I 20
0-229
2-264
I1073
0?495
2-093
(0-562)
I-833
2-125
I1764
2605
2042
2-036
(3, 28)
I*oI8
(I,
3I)
Notes: See Table 2. Superscripts n and e refer to all non-election and post-election years, and superscript
t refers to the Thatcher years.
employment, any of these governments would, in non-election years, generate
the same expected and actual inflation. The estimates also confirm the electoral
predictions of our model for Labour and pre-Thatcherite Conservatives. In
election years inflationary expectations are higher than in non-election ones,
and, as a result, wage inflation is higher by almost two and a half times the rate
of lagged unemployment. This difference is statistically significant at 5 00.
The exception is Mrs Thatcher. On the basis of our estimates, the Thatcher
governments were not expected to behave any differently in non-election and
election years.
There are two possible explanations for this difference between Mrs
Thatcher and the rest. One is that the probabilities of re-election of the
incumbent changed after I 980, in view of the crisis in the Labour Party. If the
probability of re-election of the incumbent was estimated at i, there would be
no difference between election and other years for the Thatcher governments.
This explanation is one possibility, although maybe not the most plausible one.
A second explanation is that the behaviour of the Thatcher government once
I390
THE
ECONOMIC
JOURNAL
[NOVEMBER
it was elected in I979 managed to establish a credible anti-inflationary
reputation. Even if money growth rules, the Medium Term Financial Strategy
and the like were above their target ranges, the recession in the immediate
aftermath of the election may have convinced wage-setters that the electoral
cycle was gone for good, and this may be why no resurgence of inflation was
expected in the aftermath of the I983 and I987 elections.23
In conclusion, under managed exchange rates, and before Mrs Thatcher,
there is strong support for the 'pure' version of partisan models for the United
Kingdom. The preferences of different parties between inflation and
unemployment do not seem to differ. Given lagged unemployment, UK
political parties were expected to generate the same rate of inflation in nonelection years. In election years they were expected to generate significantly
higher inflation, with the exception of Mrs Thatcher whose behaviour in her
first two years in office may have dispelled the expectation that future elections
would be followed by monetary relaxation.
III.
CONCLUSIONS
This paper extends the basic partisan model of inflation and unemployment to
allow for unemployment dynamics. The extension turns out to be important
because if unemployment persists, any reduction in unemployment through
unanticipated inflation will have future as well as current benefits for the party
in power. Thus, the distance from the next election will affect the incentives of
governments to create unanticipated inflation to reduce unemployment. We
demonstrate two main results: First, that if socialists care more about
unemployment than conservatives, they would be associated with higher
inflation at any point in their term of office. This generalises the basic Alesina
(I987) result to the dynamic case. Our second main result is that if the
preferences of political parties are close enough, inflation would be higher
under both parties in the period following an election than in non-election
periods. This prediction of our dynamic model is in sharp contrast to the case
without unemployment persistence examined by Alesina (I987) and Alesina
and Sachs (I988).
We test the predictions of the dynamic model for the British economy,
combining the political model with a model of exchange rate regimes, which
predicts that inflation should not systematically differ with the party in power
or elections under credible fixed exchange rate regimes (Giavazzi and
Giovannini, I987). This is because fixed exchange rates take away the ability
of governments to create surprise inflation.
Our empirical findings suggest that the exchange rate regime matters greatly
for expected price inflation and thus nominal wage growth. One cannot reject
the hypothesis that wage inflation in the Bretton Woods system of fixed
exchange rates has been independent of the party in power and the timing of
elections.
23 The possible effects of the I 980 deflation on the anti-inflationary credibility of Mrs Thatcher have been
investigated by, among others, Buiter and Miller (I98I, I983), Backus and Driffill (I985), Begg (I987),
Goodhart(I989) and Beanand Symons(I990).
I992]
ELECTORAL
UNCERTAINTY
AND
INFLATION
I39I
In the period of managed exchange rates that has followed the collapse of
Bretton Woods, there seem to be very small differences between Conservative
and Labour administrations, especially in non-election years, and when one
allows for a change in regime under Mrs Thatcher. Our prediction that postelection years are associated with higher wage inflation seems to be borne out
in general. However, during the Thatcher years there has been no difference
in wage inflation between election and non-election years, an indication that
some form of anti-inflationary credibility was established by the governments
of Mrs Thatcher.
We close with some qualifying remarks. First, our empirical tests have
concentrated only on wage equations, while the theoretical model has
predictions for price and unemployment equations as well. The wage equations
are particularly important in the context of this theory, as it is through them
that expectations of inflation affect unemployment. One possible extension is to
further test the full model using the cross equation restrictions between wage,
price and unemployment equations. This may allow us to distinguish between
our model and opportunistic models with sluggish price adjustment, and is left
for future work. Second, it should be borne in mind, that as with almost any
empirical results, our findings could be interpreted differently. As a referee has
pointed out, it would be possible to interpret some of our dummy variables as
reflecting shifts in the natural rate of unemployment, rather than shifts in
expectations about inflation. Possible other omitted variables could also have
biased our results. However, we feel that the pattern of our findings is consistent
with the theory we have put forward, and we claim no more than that. Given
the limited number of economic and political episodes in our sample, we have
found that attempts to allow for too many different shifts, result in nearcollinearity among the regressors, and fail to provide additional information.
BirkbeckCollege, Athens School of Economicsand CEPR
Birkbeck College, University of Exeter and CEPR
University of Essex
Date of receiptoffinal typescript: June I992
APPENDIX
I
Analysis of the Partisan AdvantageModel
Here, we establish analogues of Propositions I-4 in the text, but for the partisan
advantage version of the model. The equations defining the equilibrium are as in (i o),
(i i), and (I 2), except(i) ( Io b) is replaced withhT, = ql7?q + qci', (ii) Ze replacesorin (I2 b),
(I 2 C); (iii) q is replaced by qtin ( II b). Because the incumbent party no longer has any
effect on the outcome of the election, both 87T and /?e are now independent of the
identity of the incumbent, and so the political equilibrium is now characterisedby four,
rather than six pairs, 7i4,Pe, 74nfl , that solve (II) and (I2) with the appropriate
modifications as described in (i)-(iii) above. We then have the following results:
thenfor q',qc closeenoughto ? 5, 7Te> 7Te', Fn > 7Te
o 5 in the proof of Proposition I: this establishes the result for
PROPOSITION A I. If a' > a'
Proof. Set q =
I 392
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ECONOMIC
JOURNAL
[NOVEMBER
qC = q = 05. The result then follows by continuity
parameters. I
PROPOSITIONA 2.
of the
f
and
7T
in the
Expectedinflationin electionyears is independent
of the identityof the
incumbent.
PROPOSITIONA 3.
With myopicpreferences,
i.e. 8
= O,
7T'
Proof. If 8 = o, 7 = oci, so this follows immediately
modified following (i)-(iii) above. I
>
7Tn, 7Te < 7T.
from (I2a-c),
PROPOSITION
A 4. If Occ= ocx= ac, and qCis close to ql, then 7T'
> iT4,
i
=
appropriately
c, 1.
Proof. Set q = 0o5 in the proof of Proposition 4; this proves the result for qc_ ql =
fl and 7T< in the parameters. I
o05. The result then follows by continuity of the
APPENDIX
2
Incumbencyor Partisan Advantage?A Direct Test
The two special models of electoral uncertainty that we utilise, namely the incumbency
advantage and electoral advantage model, are both special cases of a model in which
both incumbency and the identity of parties matters for their probability of winning an
election.
Assume that p is the probability of a Labour victory if Labour is the incumbent, and
q the probability of a Conservative victory if the Conservatives are the incumbent.
Obviously the probability of a Labour victory if the Conservatives are the incumbent
iS I - q, and the probability of a Conservative victory if Labour is the incumbent is
I-p.
Against this more general model, the partisan advantage model implies the
restriction that q = I-p, and the incumbency advantage model implies the restriction
that q = p.
To test the restrictions implied by each of the models, we have used the data on all
UK elections since I952 to estimate the election probabilities with and without the
restrictions implied by the incumbency advantage and partisan advantage models.
Given the UK election results, the unrestricted likelihood function takes the form,
L = kq4(i_ y)2(
q
I _ p)2p2,
(A 2. I)
where k is an arbitrary constant, reflecting the unconditional probability of the
Conservatives being the incumbent in the first post-I952 election of I955. The
maximum likelihood estimates can be derived by taking the first-order conditions of
(A 2. I) with respect to p and q.
The maximum likelihood estimates of the unrestricted model are p = 2 and q = 2
The maximum likelihood under the restrictions of the partisan advantage model (q =
-p) yield q = 5. The likelihood ratio test for the restriction is equal to 028, well below
the 5 0 value of x2(I) = 3-84. Thus, the restriction of the partisan advantage model
cannot be rejected. On the other hand, the maximum likelihood estimates of the
incumbency advantage model (q = p) also yield an estimate of q = 5. The incumbency
advantage model has the same likelihood as the partisan advantage model. Of course,
its restrictions cannot be rejected either. The results of the io elections held since I952
are not informative enough to allow us to discriminate between the two restricted
models, and none can be rejected against the unrestricted one. Conditional on the
incumbency model, the incumbent has a 6o0% probability of being re-elected, and
conditional on the partisan model, the Conservatives have a 6o0 0 probability of being
elected in any given election.
I992]
ELECTORAL
UNCERTAINTY
APPENDIX
INFLATION
AND
I393
3
Proof of Proposition I
We give here an outline of the proof; the full version is available from the authors on
request.
(i) Consider the following finite-horizon (T-period) version of the game between
political parties and wage-setters. Label time backwards, and suppose without loss of
generality that the last period, period i, is a non-election year, and that T is even, so
that period T, the first period, is an election year. Then, fin and ,fl,(i)will be timedependent; redefine fl,, = l, /e t(i) = yt to avoid an excessive number of subscripts.
Then, it is easy to check that the recursion equations (I I a), (i I b) become;
7T
t) )2] i
[(7Ti)2+
t (Ot+ 8_fi)t . (A_(7Ti_ t
i.=-min
= J'
ue
t even
A 3.1)
.I
~~~~(A
iT1t
=
min[()2+
.)
(at'+ q.8&
. (A - (n-_
t) )2] i
=
l,c) t odd
(A 3.2)
lit
where in both cases the wage-setters, expectations 7Ttare taken as exogenously given,
and are defined by the analogues of (ioa) and (iob) i.e. lit = T, t odd, i incumbent at
t+ I , and lit = q. 7Trt+ (I -q) .7et, t even, i incumbent at t+ I. Also, there is the initial
condition that y1 = o, as in the last period, period i, future losses are zero.
(ii) Given (A. 3.I) and (A. 3.2) and this initial condition, it is possible to show that;
(a)
At' 2
fly,t even, y' >
at,
t odd, for all t = i,. . T; (b) {fi}ti2t4.2.T and
{Yi}t=1,3..T-1
c, are monotonically increasing bounded sequences, and so have limits as T-? co.
Proof of property (a) and monotonicity is by induction and is straightforward; the
details are omitted. To show boundedness, note that both P, t even, and yt, t odd, are
bounded above by /3t, where flt.U2 iS the present value of loss over t periods, starting
with unemployment ut, to a government which is perpetually in power, and has a
weight on unemployment of xl. (The reason for this is that in the T-period game, for
any given sequence of inflation rates, the higher ac, and the larger the probability of
staying in power, the greater the present value of losses to the government; this can
easily be proved formally by induction.) It is possible to show that lim ,Bt = /?exists
i=1,
t-oo
and is finite as long as a.A2 ? [(I+xt)-2.(&)/112]/(I_al)
=
B (see Lockwood and
Phillippopoulos (iggi) for the details). Also, flt is monotonically increasing. So, /'t,
gty< Alt < fl, all t.
and lim ?7' = i, i = 1,c exist and are
(iii) From the resultsin part (ii), lim =T
T ->,o
T ->oo
finite as long as d. A < B, as monotonic bounded sequences always converge.
Furthermore, as the right-hand sides of (A 3. I), (A 3.2) are continuous in /At,y', i=1, C,
taking limits as T-*oo in (A 3.1), (A 3.2) yields the recursion equations (II a) and
( I b) in the text. So, (fl, i), i = 1,c jointly solve these recursion equations. Therefore,
1,c we have shown that there exists
making the identifications =lt= fn,
Ie(,=
a unique political equilibrium in the infinite horizon game which is the limit of finitehorizon equilibria, as long as <.A2? B. Furthermore, as flP_= B, t even,
yt, t odd,
for all t = i,. . T, these inequalities are preserved in the limit as T-* o, so ?l>
I3'(1)> /Be(c). So, as a' > ca',it follows that in the limit equilibrium, y7 > yn, 0/> ye.
Then, I > d1> dc, so from
7TC,as required.
(I2 a)-(I2C)
in the text, it follows that 7T4(i) > 7T'(i),
2T >
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