Essays On Policy Dynamics Under Political Frictions

The successful design and implementation of macroeconomic and public policies has an important political dimension. This dissertation, which lies at the intersection of macroeconomics and political economy, focuses on understanding the dynamic fiscal and regulatory policies in the context of political conflicts and special interests. The first essay, Curse or Blessing? On the Welfare Consequences of Divided Government and Policy Gridlock, studies the welfare consequences of divided government by analyzing a dynamic legislative bargaining model with endogenous status quo. By comparing a unified government where the opponent's approval is not needed with a divided government where unanimity rule applies, I show that with divided government tax policy is less responsive due to gridlock and is distorted due to dynamic strategic considerations. However, the welfare consequences of such a policy are mixed because gridlock also reduces policy fluctuations created by political turnover. In the simulated economy, I find that divided government can Pareto dominate unified government. While this phenomenon prevails at various levels of inequality and political polarization, the set of initial status quo tax rates allowing for it shrinks as inequality and political polarization rises. Moreover, as income inequality rises, on average divided government benefits the poor while hurting the rich. This is because households at different income levels trade off potential gains and losses from policy gridlock differently. The second essay, Political-Driven Financial Regulatory Cycle, develops a positive theory of political-driven financial regulatory cycle. The key feature of the model is that the regulatory policy is determined through the interaction of financial sector special interest group, politicians competing for office, and households with time-varying attention on financial regulation. I find that in absence of the special interest group, politicians maximize the utility of households and implement stringent regulation. Once the special interest group is introduced, the politicians are induced to behave as if they were maximizing the weighted sum of utilities of the financial industry and strategic households. In symmetric equilibrium, politicians' policies converge and they choose the regulation such that the electoral loss due to weakened support from households equals the electoral gain created by campaign contribution. Moreover, the equilibrium financial regulation turns out to be pro-cyclical. During financial market expansions, the financial regulation remains largely ignored by the general public. Hence the policymaker cater to the financial interest group and promote loose regulation. Once financial crisis takes place, the public attention on regulation is brought up. For fear of upsetting the voters, the politician is forced to tighten the regulation. The third essay, Evaluating Durable Public Good Provision using Housing Prices, is collaborated work with professor Stephen Coate. Recent empirical work in public finance uses the housing price response to public investments to assess the efficiency of local durable public good provision. This paper investigates the theoretical foundations for this technique. In the context of a novel theoretical model developed to study the issue, it shows that there is limited justification for the technique when a budget-maximizing bureaucrat interacts with rational, forward-looking citizens. A special case in which the bureaucrat faces no vot- ing uncertainty is solved in closed form to show why the technique can falsely predict under-provision. In the generalized model which involves randomness of voting outcomes, we show numerically that the technique may falsely predict both under-provision and over-provision of local durable public good. The technique is valid, however, when citizens have adaptive expectations, believing that whatever provision level that currently prevails will be maintained indefinitely