Freeman - Houser - 1988 -- A Computable Equilibrium Model for the Study of Political Economy

7/28/2019 Freeman - Houser - 1988 -- A Computable Equilibrium Model for the Study of Political Economy

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A Computable Equilibrium Model for the Study of Political EconomyAuthor(s): John R. Freeman and Daniel HouserSource: American Journal of Political Science, Vol. 42, No. 2 (Apr., 1998), pp. 628-660Published by: Midwest Political Science AssociationStable URL: http://www.jstor.org/stable/2991773

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A Computablequilibrium odelforthe tudy fPolitical conomy*JohnR. Freeman, University f MinnesotaDaniel Houser, University f MinnesotaTheory: he needfor hedevelopmentnd use of a concept f oint, olitical-economicequilibriums increasinglyecognized y studentsfdemocracy nd markets.et,todate,noadequate heoreticalndmethodologicalynthesisf thiskindhas beenpro-duced.The fewworkswhichhave ttemptedt sufferrom lack of theoreticalalancebetween conomic ndpolitical heory;nrealistic,emporallyggregatedonceptionsfpolitical-economicquilibrium;ailureo ncorporateheoreticallyeaningfultochasticelements f economic ndpolitical rocesses; nd the bsence f a coherent ethodol-ogyfor auginghe mpirical ower fpolitical-economicodels.Methods: n the pirit ftheAJPS workshop,t s shownhow theseproblems anbesolved.Animprovedmodel s built, ne whichfuses branch f real business ycletheoryndthe heoryfpresidentialpproval. hismodelproduces notion fcomput-ablepolitical-economicquilibriumhat rovides ormarketlearingnd simultaneousstochastic ptimization y economic nd political gents.Then,usingdata analysistechniques evelopednparallel yrealbusiness ycle heoristsHansen nd Heckman1996; Kydland nd Prescott 990, 1996; Lucas 1987; Prescott 986a, 1986b, 1991;Sims1996)andpoliticalmethodologistsBrady1996; Jackson 995),themodel s pa-rameterizedor heUnited tates.Morespecifically,n thebasis of estimatesrom co-nomics ndpolitical cience nd somenumericalxperimentation,ertain f tsparam-eters re set so that,whensimulated, he model mimics he UnitedStatespoliticaleconomynthe1980s.Results: he parameterized odel s used to study ome mportantounterfactuals.hefirsts the mpact f ncreasedpproval olatilitynpolitical-economicquilibration.SuchvolatilitysexpectednviewofAmerica'sikelynvolvementn thepostColdWarera's ncreasingumber f "low ntensity"nternationalonflicts. he second s the m-pactofpresidentsursuingelativelyigh-nonminimum inning-levels fapproval.This kind f behaviors attributedo certain residentslongwith he laim hatt hasharmfulffectsnmarketsnd henceon various acets f social welfare. he former

*This s a much ondensed ersion f a paperdelivered t the 1995AnnualMeeting f theAmeri-canPolitical cienceAssociation,heHubert umphreynstitute'seminar n Trade nd Develop-ment,ndon theCommitteeor nstitutionalooperation's olitical cience, nteractiveideo emi:nar.The authors ratefullycknowledge heresearch ssistance f Paul Kellstedt nd MarceloVeriacertond theresearch upport f theNational cienceFoundation. oruseful ommentsndcriticisms e thanknonymouseferees, amesGranato, obert olt,John ackson, en Kollman,GeorgeKrause,EricLawrence,do Oren,Diana Richards, erry oe,and theparticipantsntheabovepanel nd seminars. he authorsreresponsibleor hepaper's ontents.AmericanJournal f PoliticalScience, Vol. 42, No. 2, April 1998,Pp. 628-660 (D 1998 by theBoardRegentsftheUniversityfWisconsin ystem


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ACOMPUTABLEQUILIBRIUM ODEL 629analysis howshow "business yclephenomena"Lucas 1987) canbe traced,n part, ogovernmentpprovalmanagementn anincreasinglyolatile nternationalolity,man-agement hich s associatedwith slight rop n social welfare. he atternvestigationdemonstrateshat hepresident'sursuit f a consensual pprovalargets notnecessar-ily ocially armful.

At he eart f he tudyfdemocracyndmarketsre he evelopmentand nalysisf onceptsf conomicquilibriumndpoliticalquilibrium.Recently, anycholars ave rgued hat he wo ypes fequilibriumreintimatelyelated,marketquilibriumepends o some xtentn the ut-comes fpolitical rocessesndthese utcomesinge nmarketlearingand related conomicprocesses. t s theointorsimultaneousquilibrationofmarketsnddemocracyhatmust eunderstood.hecounterfactualshatdrive heory uildingneconomics ndpolitical cience annotbe ad-equatelynalyzed ith neequilibriumonceptlone.Unfortunately,ew cholars ave ttemptedhenecessaryheoreticalandmethodologicalynthesis.ake, ornstance,wo f hemajordvancesof he 980s: ealbusinessycle heoryndour heoryf pproval anage-ment. hemotivationfagentsnthe ormersdefinedolelyneconomicterms;he tochasticlementsf hemodels re ied o economicrocessesalone; henotion fequilibriumas to dosolelywithmarketlearing ithnoprovisionor tabilitynthe oliticaltrategiesfgovernmentrepresen-tativegents).mprovementsnthe erformancefrealbusinessyclemod-els are oughthroughhentroductionf dditionaltochasticlementsikefiscal hocks,he oliticalrigins fwhich renever xplored. eanwhile,approval heoristsontinueobuildmodelswithoutny quationsor heeconomy.ationalizationsor pprovalpecificationsrenot rovided-re-duced ormsontinueobe used nd he tochasticermsnthemsuallyrenotnterpretednany ubstantivelyeaningfulay; henotions fequili-brationssociatedwith hese educed ormpproval quationsrenotde-rived romhe ehaviorf ny ationalgent,et lone he gents hichp-pearin macroeconomic odels.For example, henowpopular rrorcorrection odel s not hown o bethe esultfthe ationaltrategiesfanypolitical gents.Methodologically,he ime eries ecompositionndother ata nalyticechniquessedbyrealbusinessycle heoristsreno-whereobefoundnthe pprovaliteratureFreemanndStimson 994).Real business ycle ndapprovalheoristshusworknseparate ealmswithoutnymeaningfulntellectualxchange. s a result, ossible ainsfromrade etweenhese wo odies fworkrenot ealized. ndmportantquestionsbout uch hingss thempact hichncreasingnited tatesn-volvementn"low ntensity"nternationalonflictsnthepostColdWar


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630 John .Freeman nd DanielHouserworldmight aveonapproval olatilitynd, nturn,nmarketsndeco-nomicwelfareemain nanswered.1Ofcourse, few cholarsave ttempteduch synthesis.able1 sum-marizes omeof themost ecent f these ontributions.onsider,or x-ample, hework nder he econd olumn.2hesemodels sually rovideforwo-partyompetitionndermajorityrpluralityule. achpartynd tsconstituencys assumed ohavedifferentbjectives. overnments con-ceived ither s a self-interestedncumbentarty,nagentwhichmple-ments bargainetween arties,ranagentwhose bjectives tooptimizethe roductfthe arties'tilityunctionsseebelow).Governments con-strainedn these egards ya setofeconomic ndpoliticalelationshipsr"lawsofpoliticalnd(or) conomicmotion." olicy huss the olutionothe espectiveonstrainedptimizationroblem.Themostwell-knownorknthis enres arguablylesina's esearch(1987,1988),ncludingispaperwith ondreganndRosenthal,A Modelof he oliticalconomyf heUnitedtates"1993).TheAlesina, ondre-gan, ndRosenthal odel ncorporateseynstitutionsfAmericanepre-sentativeovernment.or nstance,tprovidesor residentialnd ongres-sional lectionsndforointdeterminationfpolicy utcomesythe wobranches.artiesompetena stochasticorld; rowthepends,npart,nshocks epresentingnanticipatedconomic ventsndfluctuationsn"po-litical ompetency"administrations'bilities oavoid nefficiency;f.RogoffndSibert 988).Therange fvoters'referencesornflationndgrowtharies andomlyach lectoral eriod. artyompetitionroduces

'The newmacroeconomicsngeneralndrealbusiness ycle heorynparticularrereviewedelsewhereFreeman 993).Briefly,hisworks associatedwith he esearch fLucas 1980, 1987),Prescott1991), and others. mong therhingst ntroduceshenotions f stochasticconomies,e.g., conomieswith roductionunctionsnwhich he mpact ndevolutionf echnologysinher-ently andom. he behaviorf the ompetitiveconomys shown obe equivalento that f a be-nevolentocial planner hoengages nstochasticptimizationStokey, ucas,andPrescott 989).That his choolofeconomicsargelygnoreshepoliticalmotivationsf agentss evidentn suchworks s Chari, hristiano,ndKehoe 1991, sp.529); Barnett, inich,ndSchofield1993,466);andMcGrattan1994,esp. 9). Some approvalheoristsest or he xogeneityf elected conomicvariablesMacKuen, rikson, nd Stimson 992).But,usually hese heoristsssume hat he en-tire) conomys exogenous.With ne or two xceptionsDurr1993), here s no rationalizationfthe pproval unction.he notion fequilibrationasto dowith he ime eries ropertiesf he p-proval ataratherhan ny deaofmarketlearingndrelated onditionsor ompetitiveconomicequilibrium.llustrativef this s thenotion f a moving quilibriumnapproval, nemployment,and nflations governedyan errororrection odelECM); see OstromndSmith1993). Politi-cal scientistsavenotmade ny ttempto ink he CM tothebehaviorfany ational oliticaloreconomic gents. his s in spite f thefact hat uchrationalizationsave existed or ometime(Nickett 985).2To avespace,only subset f theworksnTable 1 are reviewed ere. hefull eview s inFreeman1995).


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632 John .Freeman ndDanielHousercoalitionroof ash quilibriumhatonnotesime onsistentolicies ndparticularatternsfgrowth.his quilibriumlso mplies patternf lec-toral utcomes hich reconsistentith ey actsbout uch hingss therecurrencefdividedovernment.Lesserknown ut quallymportantontributionsn this enre avebeenmade yEuropeancholars.or nstance,anderPloeg 1987)usesatwo-partyompetitionodel oexplorehemplicationsfrationalxpecta-tions nsmall peneconomieswith ncertainlectoralutcomes.nhismodels,hedomesticeal nterestate spegged o the oreignnterestate(whichsexogenous),peculatorsrerisk eutral ith erfectnformationandforesight,ndgovernmentsa Stackelbergeaderwhosencumbencysdeterminedrobabilisticallyhroughlections. an derPloegcomparespolicy hoicewhen overnmentsabenign lannero hat henncumbentsfacepossible lectoralefeat,howinghatn the atterituationoliticallyinducedwingsn the conomyanoccur s governmentnticipatesosingofficend akes ctionsooffsethe ffectsf ts uccessors'olicies.3Anotherontributions madebyDrissen ndvanWinden1993).Theyconstructmodel asedonformalheoriesftwo-partyompetitionndermajorityule ndprobabilisticoting.nparticular,rissen ndvanWindenexploithe esult hatwhenndividualhoice robabilitiesreproportionaltotheirtrengthfpreferences,overnmentillmaximizeheNashproductof the mplicittilityunctionsfthe woparties'onstituentsCoughlinandNitzan 981;Hinich 977).Using his esult,he ssumptionhat heconstituentsf he wo artiesre abor nd apital,nd naugmentedet feconomiconstraints-augmentednthe ense hatublicectorroductionis added othe quationsonventionallysedtorepresenthe ompetitiveeconomy-DrissenndvanWinden re bletochallengehe onventionalwisdombout iscal olicy. or nstance,hempactfa tax ncrease eednot eadtoa reductionnprivateectorroductionsitdoes npartialqui-librium odelsnwhich ax hangesrenot onstrainedypolitics.4

3InvanderPloeg'sset-up oreignnterestates retreateds exogenous ausesofchangesndomestic eal nterestates. ationalxpectationsre nthe orm fumpvariables;hats,variableswhichreforwardookingndnot onstrainedypasthistory.umpariables redeterminednef-ficient inancialmarketsnd take nto ccount xpectationsffuturevents o that redible n-nouncementsfchanges nfutureconomic olicy ffect he urrenttate f the conomy. ealcompetitivenessndrealexchange ates re umpvariablesn themodel. artiesmaximizelterna-tiveobjective unctions,unctions hich rediscountedverperiods felectoral ncertaintyntermsftheprobabilitiesfreelectionf ncumbents.ee alsovanderPloeg 1984).4Stochasticlements re mplicitnDrissen ndvanWinden's iece 1993). No expressionsforprobabilistic oting re made in theequation ystem.Governmentimplymaximizes heweighted roduct fthe wo ctor's tilityunctionsVC,Vw);heweights reofthe influence"a-rietyP = VWCV'w where + pu =1). Political conomic quilibriums defineds the ointmaximizationfhousehold ndgovernmenttility here heformerreatsolicy s given nd thelatterreats ouseholdmaximizations a constraint.


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A COMPUTABLEEQUILIBRIUM MODEL 633Thesemodels re mong hemost romisingnterdisciplinaryynthesesconstructedodate.Among therhings,hey xpresslyncorporateoliticalmotivationsor gents.nsome ases, heirreatorsttempto how hat hemodels anexplain mpiricalatternsfvarious inds.Unfortunately,s models fpolitical-economicquilibration,heseworks restill eficientn a numberf mportantespects.obeginwith,themodels ften onot trike meaningfulalancebetween conomicandpolitical rocesses. orexample, hepolityntheDrissen nd vanWindeniece sunderdevelopednan mportantespect:he tochastica-ture fthepolitical ehavior s implicit ot xplicit.n thecase oftheAlesinawork,t s the conomy hich s underdeveloped-aimple up-plyfunctionbsent f any conomic ationalizations all thats provided.In effect hen, lesina'smodelshavenoeconomic gents.5 econd, heconceptionsfpolitical-economicealitynthese- odels rehighlyem-porally ggregated.olitical-economicquilibriare realized nlywhenpresidentiallections ccur; n this ense, theworld tartsver very ouryears" Alesina, andregan,ndRosenthal993, 6). Third,hesemodelsusually ail oprovide or tochasticlementsnthe conomyndpolity.In almost ll the ases,deterministiconceptionsfproduction,oting,and other eyprocesses reemployed espite hefact hat heory owstresses he mportancef suchfactors s technologicalnnovationndrandomnessnpreferences.oncomitantly,here s stillno relation e-tween heformalmodels ndreduced ormsmployednthis esearch.The mostglaring xamples f this roblemreAlesina'spapers 1987,1988)wherehe ationalxpectationsusiness ycle et-up earsno rela-tion o the quations hichrefit o data ndno nterpretationfthe rrortermnthe tatisticalet-ups supplied. s synthesesfeconomicsndpoliticalcience hen,hesemodels re mportantdvances ut tilln needof ubstantialmprovements.65Alesina'smodels epresenthe conomy s a single quation-the ucas supply unction. ismodels o notprovide or ptimizationyeconomic gents. he ack of balance s evident ven nthenewest nd best ontributionsuch s Barnett, inich, nd Scofield's olitical conomy:nsti-tutions, ompetition,nd Representation1993). This book s trulytate fthe rt.However,mostofthe rticlesn t tudy hepolity n solation fthe conomy.6As regards o thefourth oint, lesina, ondregan,nd Rosenthal'smodel 1993) is genu-inely tochastic. nd heres a more irect elation etweent ndthe stimationquations. ut hisrelations notone-to-one. ather,heirmaximumikelihood unctionontainsmechanisms"hatarenot n their ormalmodelsee esp. 1993, 1). Neither anderPloegnorDrissen ndvanWindenpresentnygeneral trategyor sing heirmodel o explain he bserved ehaviorfextant oliti-cal-economicystems.nthe ase of the ormer,he uthorifts arametersrom British reasurymodel;hepresentsimulationesults ut oes not ttempto show hat he esults xplainhehistoryof Britain r ofanyotherountry.rissen nd vanWinden's nalysisspurelybstract. hey ffernoparameterstimatesor heirmodel r tatisticalests f ts mplications.nprinciple,hemethod

presentedelow ouldbeusedtogauge he mpirical ower fbothmodels.


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634 John .Freeman nd Daniel HouserIn the piritf he JPSworkshop,his aper hows ow hesemprove-mentsanbe made.Realbusinessycle heorynd heoryf pproval ain-tenance refusednways hatncorporateationalconomic nd politicalbehaviors well s key tochasticlementsfpoliticalndeconomic ro-cesses. nparticular,hemodern heoryfoptimal iscalpolicy Chari,Christiano,ndKehoe1990,1991) smerged ith oliticalcientists' orkonpresidentialpproval.s nthe ormer,ax ates nd nterestatesnpub-lic debt ptimizehe iscountedresentalue f he eturno representativehouseholdnkeepingwithwell- stablishedconomiconstraints.irmsmaximizerofits.nd ricesndwages re uch hatmarketslear. utheretherelso sprovisionor oliticalccountability.s in our oliticalheory,householdsispensepproval.ndgovernmentsmotivatedo chievepar-ticularpproval atingBrody1991;Ostrom nd Smith 993;Williams1990).More pecifically,heres an approvalonstraintnd politicallyo-tivatedgentwhominimizes hediscountedresent alueofexpectedsquaredeviationsromts pprovalarget.naddition,hemodel s definedintermsfthe oint ealizationfthree andom ariablesepresentingech-nological nnovation,overnmentpendinghocks, nd approvalhocks.There mergesromhisonstruction,conceptf omputableolitical-eco-nomic quilibriumhat escribesmarketlearingnd, imultaneously,to-chasticptimizationyeconomic ndpolitical gents. hecorresponding,"politicallyotivatedllocationroblem"ssolved or he ecision ules fboth gents. hen, sing ata nalyticechniquesevelopednparallel yreal business ycletheoristsHansen nd Heckman 996; KydlandndPrescott 990,1991,1996;Prescott986,1991; ims1996)andpoliticalmethodologistsBrady 996;Jackson995),themodel s applied o theUnited tatesnthe eriod 980-90.On the asis f stimatesromcodiom-ics andpoliticalcience-andumericalxperimentation,ertainarametersinthemodel re et o thattmimics heUnitedtates,hats,when imu-lated,hemodel roducesime erieswhich, hen etrended,ave ropertiesthatreveryimilaro those fdetrendedctual ata nthe ndicatedimeframe. hedetrendingethods that sedbyrealbusinessycle heoristsand mplicitnpoliticalcientists'nalysesfcitizensppreciationfeco-nomic easibilityonstraints:heHodrick rescottHP) filterHodrickndPrescott980).Finally,hemodel s used o studyome mportantounter-factuals. ne of hese s mentionedbove: he conomicndwelfareonse-quencesf he ncreasesn pprovalolatilityhich merica'sncreasingn-volvementnthe ostColdWar's low ntensity"onflictss ikelyo pawn.The others an assessmentf thepoliticalndeconomicmplicationsfpresidentsursuing igh-nonminimuminning-approvalevelsor, fwhat s called uphemisticallyresidentsloving angerously"TheEcono-mist, anuary4, 1994,21-4). The formernalysishowshow business


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A COMPUTABLE EQUILIBRIUM MODEL 635

cyclephenomena"Lucas1987)canbetraced,npart,ogovernmentp-provalmanagementnan ncreasinglyolatilenternationalolity, anage-ment hichsassociated ith slightropn ocialwelfare.he atternves-tigationemonstrateshathepresident'sursuitf a consensualpprovaltargetsnotnecessarilyocially armful.n theseways,he esiredheoreti-cal andmethodologicalynthesiss achievednd tsvalue s demonstrated.7A ComputablePolitical-EconomicquilibriumModelTheEconomyAssume hat he epresentativeouseholdrderstochastictreamsfcon-sumptionnd abor y:

maxE, ptu(st)U[c(st), (st)] [1]C t SIwhere3 sitsdiscountate,t s the tate f he oliticalconomyttime ,u(st)representsheprobabilityhat particulartate ccurs ttime ,andU[ ] is thehousehold'strictlyoncave tilityunctionncreasingncon-sumption,,anddecreasingn abor,X,where and l dependnthe tate,St.8Say, roductionechnologys definedy

y = Z(St)(1 + p)tf(t) [2]orthatutputs a functionnly f abor ut lso of "growthactor"ndstochasticrocess, . The term 1+ p)t representsositive xogenous

7Our model hus s in the pirit fthework fAlesina,Londregan, nd Rosenthal 1993),Brady 1996), Brady ndAnsolabehere1989), andJackson1995). For nstance, nlikeJackson's(1995) set-up,n ourmodel, he ehavior fpoliticalandeconomic) gents refully ationalizedntermsfoptimizationheory; oliticalconomic ealitystemporarilyisaggregated-equilibrationoccursmonthlyrquarterlyot very our ears; nd,ourparameterizations basedon numericalexperimentsor particularraof United tateshistory.n comparisono themodelofAlesina,Londregan,ndRosenthal1993),our et-up as a full lown conomy ith ptimizingouseholdsand stochasticoliticalndeconomic rocesses.Space restrictionsonotpermitfull escriptionndevaluationftheHodrick-PrescottHP)filter. riefly,hisfilters used todecompose ime eries nto long-termomponentroughlygreaterhan 2 quartersr ow frequency)nda medium/shortermomponentmediumohighfrequency). eal business ycle heory olds hat hedecompositions essential ecausedifferentforces etermineachcomponentcf.Lucas 1980,1987).Paralleldeas nthepolitical conomyit-eraturereembodiednAlesina's1988) andAlesina, ondregan,ndRosenthal's1993) concept fnatural rowthates. he filters describednmore etail ntheAppendixothis aper. hisAppen-dix is available at the Political Methodology aperArchive http://wizard.ucr.edu/polmeth/polmeth.htm1].t also canbeobtainedromhe uthors.8Again,st s definedelow n terms f the ointrealization f ndependentroductivity,ov-emnmentpending,nd approvalhocks, ndu( ) is a Markov ransition atrixor hese hocks. f.Stokey, ucas,with rescott1989,esp. Chp. 11).


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636 John . Freeman nd Daniel Housergrowth, ? 0. In realbusinessycle heorytnormallys nterpreteds thesumofproductionugmentingechnologyhocks ver ime. is an ndi-vidual roductivityhockwhichs strictlyxogenous,ornstance,he f-fect fan unexpectedurgedecline)nthe rice fa criticalnputikeoil.Assume hat ue to such hingss nondiscretionarypendingegislation,governmentpendingrows tthe ame xogenousate, . Then he easi-bility rresourceonstrainteconciles he evelof consumptiony thehouseholdndgovernmentpending,:

C(St) + (1+ p)tg(st) < Z(st)(1 + p)tf( 3t))Thehouseholdurchasesnumberfunits fgovernmentebt teachpe-riod, . And tearnsnterestn thedebt s well swages,w, ndprofits,.Governmentays nterestnthedebt trate, ,and axeswages trate, .Thehouseholdhereforeaces he ollowingroblem:max , ptu(st U[c(st),?(St)] [4]C t SI

such hatc(s') + b(sl) < (I - T(sl))w(slr)?(sl)+ V(sl) + R(sl)b(sO) + A t= 1c(st) + b(st) < (I - t(st))w(st)t~(st) R(st)b(st-l) + V(st) t= 2,3,

c(),(.) > 0, (.) < 1.That s,thehouseholdhooses onsumptionnd abor omaximizehedis-countedresentalueof tsutilityubjectoa conditionelatingts nitialpurchasesnd ts nitialwealthndthegeneralonstrainthathe um fits consumptionnd governmentebtpurchasest time s lessthan requalto the otal f tsnetwages ttime ,previousarningsromoldingdebt tt- 1,andprofitsarned tthe ime .A denoteshehousehold'sni-tial ssets. hehouseholdsassumedoown ll firms.or hese irmsom-petitivequilibriumnsureshat

v(st) = max z(st)(I + p)tf[e(st)] - w(stf((st)} [5]or, hathe rofitevel sthatwhichmaximizeshedifferenceetween ut-put ndnetwages where,gain, utputssubjectothe tochasticariable,z(st), and the xogenousgrowth actor,1+ p)t).9

9The eneral quilibriumrameworksedheremplies hat irmsptimize ndthat llmarketsclear or ach t.Theutilityunctionor ouseholdsnd he roductionunctionor he conomyrecharacterized ore ully elow.


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A COMPUTABLEEQUILIBRIUMMODEL 637ThePolityGovernments an nfinitely-livedgentwho hooses ax ates,, and n-terestnpublic ebt, , so as tominimizehe xpectedum fdeviationsfromts pprovalarget,PP*.Specifically,overnment'sreferences ofthe orm

MinXXtu(st)[(APP(st) - APP)]. [6],rR t SI,3 s thegovernment'siscountate ndu( ) isdefinedsbefore. ow, s-sume urtherhat overnmentaces wo onstraints.hefirsts expresslypoliticalnnature:

APP(st) = ?o + a, c(st) + e(st) [7](1+ +eP1(s)e(twhere c andoc representhempactfwhatwewill all"normedon-sumption"nd abornputnapproval,espectively,nde is a random rdisturbanceermepresentingallyndotherssentiallyandomhocksoapproval. hefirst ariable n therhsof[7] captureshenowwell-ac-cepteddeathat pprovalependsn citizens'material ell-being.t alsocaptureshe rgumenthat s rationalgents itizens akento ccounthefact hatonsumptionevels hange,npart, ecause fforceshat rebe-yond he ontrol fgovernments.ere his djustmentor economic ea-sibility"mountso dividing ut of c(st) theexogenously eterminedgrowthactor,1+ p)t.Thesecond ariablenthe hs f 7]representsnon-materialeterminantf pproval,pecifically,he mountf abor hehousehold ontributesoproduction. inally, he astvariable, (st), repre-sents pprovalhocks.nthe pprovaliterature,hese suallyreassoci-atedwith ne-timeurpriseomestic,nd speciallynternational,oliticalevents.0

10Politicalcientistsaveemployedhenotion fgovernmentpprovedargetingor ometime.An llustrations Schultz's1995) recentnalysis ftheBritisholitical usiness ycle.Likeus,Schultz mploys target ecallsthegovernment'ssecurityevel."Unlike s,Schultz mpha-sizeselectoraliming.We returnothis istinctionntheConclusion. nexample fthe ncorpora-tion fcitizens' ppreciationor hemacroeconomiconstraintsngovernments Chappell ndKeech's 1985) use of the xpectations-augmentedhilips urven theirsophisticated" odelofpresidentialpproval.We here imilarlyssume itizens re ophisticatednoughorealize haton-sumptionrows npart uetothe xogenous rowthactor,1+ p)t. Hence heir illingnesso dis-pense pproval aries nrelationothis rend.As itturnsut seebelow), his imple ormulationxplains large mountfthevariancenapproval. s regards(st),this ermaptures he ommon otions f"rally" r"extraordinary"p-


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638 John .FreemanndDanielHouserThesecond onstraintngovernments itsbudgetonstraint.his on-strainteconcileshenumberfunits fdebt overnmentssues nd ts axcollectionsith he eturnstpays nd ts xpenditures:

b(st) + T(St)W(st)?(St) = R(st)b(st-l) + (1 + p)tg(st). [8]Inourmodel, hen, overnmentpendings, neffect,eterminedxog-enouslyChari, hristiano,ndKehoe1991, 22)and axrates, ublic ebtissues, nd nterestates npublic ebt re djustedo cover hatpendinglevel.PoliticalEconomicEquilibriumGovernmentolicymountso a mix ftaxes ndreturnsndebt. e-fine hispolicyas =l(St)_ (t(st), R(st)). Thus thegovernmentolicy s in-dexedbythestateofthepolitical-economicorld, t.Abbreviate hegovernment'solicy s 11 l(St). Let x(5t) =_ c(st ?(st),b(st)) representthe allocation ortherepresentativeousehold or t. Abbreviate hisx =_x(st). Now thehousehold ases itsallocation ecisions ngovernmentpolicy hoices, r x(l) = (x(stll)).Andmarketquilibriummplies orprices hatw(rj)= w(stjll) ndfor rofitshatV(ri) V(stIll). t followsthereforehat politicalmotivatedconomic quilibriums a combinationofdecisions, fl*,x(.), w(.),v(.)} suchthat

I. il* solves he overnment'sroblem:Min6, E tu(st)[(APP(st) - APP *)2]tr,R t S

subject oAPP(st) = cxo+ aC + OC2t(St) e(st)(I + p) +U~

proval hocksBrody1991;Ostrom nd Smith 993). Technically,XIembodies he nitial on-sumptionevel (s?), more pecifically,=c(so)

where&a is the oefficientn themore ompletexpressionA(st) = aO + (1+ p)t(s) + i2t(st) + e(st).

We do not ttemptoparameterize(s?) here, ut atherubsumetsvalue n al .)


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A COMPUTABLEEQUILIBRIUM MODEL 639andb(stliv) c(st)w(stjI)tl(st[n) R(st)b(st-lrl) + (1+ p)tg(st).II. Foreveryl',x(fl')solves hehousehold'sroblem ith olicyrl'andprices, (f') andprofits,(il'),given.III. For veryf

w(st r) = z(st)(l + p)tf [e st1)]V(Stlfl) Z(st)(l + p)tf[e(st[rl)] W(St[l)4t(St[l).Thecorrespondingrogrammingroblemr"politically otivatedlloca-tion roblem"hens:

Min 6 itu(st)[(APP(st) -APP [9.1]suchthat

c(st) + (1+ p)tg(st) = z(st)(i + p)tf[4?(st)]E E3tu(st)[U (st)c(st) + U(Sts)tl(st)] = UC(s1)[R(s1)b(s0) + A] [9.2]t St c(stAPP(st) = aO + a, - ,+ c2y(st) + e(st) [9.3](1 p)t

c(),(.) ? O,4.) < 1 [9.4]where candUearemarginaltilitiesor onsumptionnd abor, (s?) sthe nitial tock fdebt,ndprofitsre ssumed obezerobyvirtuefouruseof heConstant eturnsoScale CRS) productionunctionelow.The olutionothe roblems derivedntheAppendixothis apercf.fn. ). Itamountsoanoptimalecision ule or he axrate nd nterestnpublic ebtnthis tochasticoliticalconomicworld.More pecifically,the ssumptionhathe hreendependentandomariablesz,g,e) ake ntwo alues ach mplieshat takes n 2x2x2 =) 8 states. heoptimale-cision ules apair fX andR for ach f hese ighttates. heuseof hesepolicy airsnthe ace fthe ealizationfthe espectivetatesminimizesthe umofthe xpectedquared eviationsnapprovalromhegovern-ment's arget hile imultaneouslyolvinghe epresentativeouseholdsoptimizationroblemnd dheringothe easibilitynd ompetitivearketconstraintsaidout bove. ubstantively,he equence feventss that hestate3-tuplef hocks)srealized, overnmenthooses tsoptimal air fpolicies hatmply,imultaneously,he hoice foptimalonsumptionndlabornputs ythehousehold,rofitsremaximized,ndmarketslear.nthe imulationelow, his ntireequences interpreteds one episode f


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640 John .Freeman nd Daniel Houserpolitical-economicquilibration,n episode ssociated ith he ealizationofthe espective-tuplefshocks. he historyf thepolitical-economicsystemsthe ecordf hese pisodes r he eries f hese quilibrations.Additional pecificationnd ParameterizationTheutilityunctions assumed ohave standardorm;hats,

{cl7(1 - YU(c,l) = UJ< 1,U ?0 [10]where,ncemore, isthe mountf ffortevotedo abor o 1- ? is lei-sure, is the o-called urvaturearameterepresentinghe elativeegreeofriskversionf he epresentativeousehold,ndyrepresentsheweightgiven o eisurenrelationo that iven o consumption.his s theutilityfunctionhat ormallys used nrealbusinessycle esearch. ith t, hemarginaltilitiesor onsumptionnd abor reI2:

UC {C1Y (1 - ?)Y}v (1 - 7)c-1 (1 - qYU -{cl-71(I _ ?)7 }NJ- . c y-7 . . (1 - f)7-1Laborefforts operationalizeds thepercentagefavailable imenet fsleepandpersonal are thats devotedowork. ollowing onventionalpracticen realbusiness ycle esearch,he vailable ime-thehouseholdtime ndowment-eachuarters assumed obe 1,369hoursChari, hris-tiano,ndKehoe1991;ChristianondEichenbaum990);and, he urva-

ture arameter,v is set qualto-1 andy is set o 66.Finallywe set hediscountate or he epresentativeousehold,3, t 99;thismplieshatnnonstochasticteadytatequilibriumhe eal uarterlynterestates 1%.13I 'Thegovernmenthooses decision ule or andR andthen dheres othis ule nall sub-sequent eriods. s regards othehousehold,tsproblems notreducible oa series ftwo-periodoptimizationroblems ecause he tate pacedoes not nclude variable epresentingheperiod.12Someofthe esultsfrealbusinessycle tudiesrederivedor n evenmore eneral lassofutilityunctionscf.Chari, hristiano,ndKehoe 1991).Also, omeresearchersake llowance

for he ntertemporalubstitutabilityf eisure,more pecifically,orvaluation f agsof eisure(Kydland nd Prescott 982,esp. 1351;Backus,Kehoe, nd Kydland 992, 1993). More compli-cated et-upsfthese indswillbe evaluatedn futureesearch.13There s little onsensus bout hevalues of the urvaturearameter. ence,researcherssometimestudy heirmodels' ehaviorsor lternativealues fpsi Chari, hristiano,ndKehoe1991) orthey mpose particularalue hatmproveshebehaviorftheirmodels Backus,Kehoe,andKydland 992). n still ther ases, someoftheparametersreestimated ith hegeneralizedmoment ethodChristianondEichenbaum990).We use the alue f 1 (cf.Backus,Kehoe, ndKydland1992; Prescott 986). Thevalueforgamma s usuallyassumed o be .66 because, nnonstochasticconomic quilibrium,his alueyields plausible esultorwork ime fabout 4%.In non-stochasticconomic quilibriumhe ealquarterlynterestates approximately -1.


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A COMPUTABLE EQUILIBRIUM MODEL 641Turningothe roductionunction,ecall hat urmodel oesnot on-tain apital.Henceproductions a functionf abor nput nly. lso, on-cepts ike nventoryBackus, ehoe, ndKydland992;KydlandndPres-cott1982)are not pplicable. ather,or implicity,e assume hat heproductionunctionas theform = 0hence '(y) = 0WO-1. In termsfour tochastic odel f he conomy,2],wehave hen

y = z(st)(1 + p)tf(t) = z(st)(1 + p)ttO [2']Real businessycle heoristsypicallyssume hat he roductionunc-

tion xhibitsonstanteturnso scale CRS). This mplies, or xample,that oublingactornputs ill xactlyouble utput.heCRS assumptionguaranteeshat rofitsre zero nequilibriumndthat he etofequilib-riumllocationsn aneconomy ith representativeirmsidenticaloaneconomy opulatedya largenumberf suchfirmsHansen1985).Wefollow his raditionnd ssume hat ur nvironmentncludes CRS pro-ductionechnology.ecauseour echnologyequires nly abor s an n-put, heCRS assumptionmplies is equalto1.0.Asregardshegrowthfactor,1+ p)t the ho arametersthe ate fexogenous,uarterly,abor-augmentingechnologicalrogress;t s the ate t which utput rowsnnonstochasticconomicquilibrium.o match he bservedate fgrowthintheUnited tatesn our ime rame f about 6% perquarter, esetpequalto 006. Recallthat heproductionrocesss stochasticnthat t ssubjectoexogenousechnologyhocks; hese hocks rerepresentedythe andomariable . Thisrandom ariable lsohaspropertiesimilaroits ounterpartn the ealbusiness ycle iterature.hat s,z is assumedofollow symmetric,wo tateMarkov hain; takes n twovalues-one"low" 1) and one"high" h); ithas transitionrobabilitiesf theformProb{zt+i zilzt Zi} = 7tfor = l,h. Usingthis ransition atrix or , weexperimentedith ifferentalues f tandofZ1lh ntilwe found param-eterizationhatmimickedmportantropertiesfUnited tates roduction.More pecifically,e found alues f tand lh such hathe tandarde-viationsndfirstrder utocorrelationsf he ullmodel's imulatedevia-tions rom P trendsn og-consumptionnd og-outputere imilar othose f ctualUnited tates ata nthe hosen ime eriod1980-90).Thefinalvalues for heseparameters re t = .91, zlow .99, andZhigh 1.01.(Note hathevaluefor t s similar o that sed nChari, hristiano,ndKehoe 991.)14

14Dataon average oursworkeder uarter ere btained romheBureau fLaborStatisticsEmployees,ours, ndEarnings, .S. 1909-1990volume ,Bulletin 370,March 1;estimatesorquarters ere onstructedrom stimatesor verage oursworked yrespective onthsn total ri-vatenon-farmstablishments.he source f theReal GNP and othermacroeconomicata s the


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642 John . Freeman ndDaniel HouserInChari, hristiano,ndKehoe 1991) andrelatedealbusinessyclestudies,overnmentpendingsassumed ogrowxponentially.e assumethe rowthactors (1+ p)t. Hencewehaveg, = g(l + p)t whererob{gt+j= gilgt gi = 0 for = l,h.As inthe ase ofourproductionunction, e ex-perimentedith lternativealues ftheparametersntilwefound pa-rameterizationhat roducedmodel imulationsnwhich hegovernmentspendingooutputationd tandardeviationnd erial orrelationfHPtrendog-governmentpending atchedhose fUnited tates ata nthechosenperiod.This s the alibration low .074,ghigh= .078 and 0 = .95.15Recall hat ur pprovalunction,7], s a simpleineardditiveombi-nation f onsumption,abornput,nd stochasticerm:

APP(st) = co + a, c(st) +2y(St)+ e(st). [7](I + p)tIdeally, ofollow he pproach sedbyrealbusiness ycle heorists, ewould arameterize7]onthe asis fmicrodata. ewould iedown he l-phacoefficientso micro bservationsysubstitutingoefficientsnto 7]that re stimatesromhe tatisticalnalysisfrelevantanelsseeFree-man1993; ee alsoBrady 996).Unfortunately,hemicro bservationse-quired or his renot vailable. heNES data napprovalor he1972-76paneldonot ontainuestionsbout onsumptionndemploymenthicharesufficientlyomparableo thepresentariables. or rethe tatisticalestimatesne obtains romhese aneldata asyto nterpretnrelationothecoefficientsn [7].16

A more euristic ethodhereforeas used.Some imple egressionswere un o obtainnitial stimatesfthe lphas. hen, sing heMarkovElectroniculletin oardof heNational echnicalnformationerviceStimsonMacropolityataSet).Thefull ata et s available ponrequest rom he uthors.Again, he ime eriodwaschosen o take nto ccount tructuraliscontinuitiesneconomicpolicyn the ate 1970s Miller ndRoberds 987)and unusual olatilitynapprovalnearly 991(Jackman995,19).Also in theperiod1980-90 the ameparty ontrolledheWhiteHouse. Thisfact iguresnthe nterpretationfthemodel elow.

15Thesamesimulationrocedures ereused toparameterizehegovernmentpending om-ponent f hemodel s for heproductionomponent.llsimulations erewrittennMathematica.Thiscode alsocan beobtainedrom he uthors.16TheNES panelfor 972,1974, nd1976contains record fapproval ecisions. owever,the espectiveatahave o do with ersonal inances,mploymenttatus fthe espondentr ofhisor herfamily,ndemploymentrospects or he conomy s a whole.Thepersonal inancesues-tionsmayberelated oaggregateonsumption.uttheres noquestion apturinghe deaofhoursworkednrelation o time ndowment.lso, the orrespondingtatisticalstimatesre of the ogitvariety,nd t s not lear hat hey ecessarilyggregates easily s macroeconomistslaim cf.Prescott 986a,1986b: sp. 14).


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chain or pprovalhocks escribed omentarily,imulationsere un orthese nitial alues.Next hese lphaswere djustedo obtain imulatedPtrendog approvalerieswhose ropertiesatchedhose f ctualHPtrendlog approval eriesfor hechosenperiod. n this nitial nalysis fourmodel,we assumed hat pprovals a functionf normed onsumptionalone.Ourvalue or (2 therefores zero; ur inal alues or t0 ndcc arereportedelow.17As regardshe andomariable , while oliticalcientistsavebeguntoexplorehe sefulnessfMarkovransitionet-upsJackman995), heyhavenot stimatedhe ransitionrobabilitiesor pproval nhancingo/frompprovaliminishinghocks. orhave heypecifiedhemagnitudefsuch hocks. owever,tudy f tandard orksikeBrody1991,Table .1)andOstromndSmith1993,Appendix ) is suggestive.nparticular,hehistoricalecord onstructedy hese uthorsuggestshe xistencef wo-state, onsymmetricarkov hainsike hosenTable2.Generallypeak-ing, he wo tudies uggestimilar robabilitiesor ransitionsrom p-proval nhancingodiminishinghocks.Where hey iffers that rody'srecord uggests somewhatreaterendencyor pproval iminishingeventsobefollowedy pprovalnhancingvents. ince hesendrelatedworks renot lear bout hemagnitudesfthese vents et fthe ight-handvariablesn [7],therespectivealuesweredeterminednthe amemanners for andg;thats,themagnitudesf hehigh and owe valueswere eterminedlongwith he lphas o create imulatedpprovalerieswhichwhenHP detrendedadpropertiesike hose or heHP detrended,actual pprovaleries. ince heirime rame ost loselymatchesurs,weuse theOstrom-Smithransitionrobabilitiesere. herescaled arameter-ization s: c0 = -.025, cc = 2.5, eloW -.0135 andehigh .0135.Again, nthis nitialnvestigation,2 is set ozero.This mplieshat he tochasticelementfthe olityroduceshockswhich ause hiftsnapprovalntherange fabout3%.1817Oncemore heHP trendnApprovals the ong-termlow frequency)omponentn that e-ries,Cf. fn. . Substantively,t correspondsosuch hings s generationalhiftsn support or heinstitutionf thepresidency,hifts hich onceivablyre tied o theHP trendn output. reating

such decompositions importantere o achieve omparabilitynthe ime rame f the wo heo-ries. ee Freeman ndStimson1994).18Clearly,hereported agnitudesfthe hocks nBrody re notnetofthe ffectsfcon-sumptionnd(or) abor.Nordo Ostrom nd Smith ffernymeasurefthe hocks; heirss simplya list f pprovalnhancingnddiminishingvents uring heReaganyears. simple egressionfapproval nnormed onsumptionor he hosen eriod roduced statisticallyignificantositivecorrelationetween he wo variables. he unscaled egressionoefficients ere ao = -106.49and a1 = 3.27. Therespectivequation ad a corrected 2 of 54. Thepositive ign f (X is con-sistent ith he onventional isdom hatitizensewardovernmentorncreasesn material ell-being ndvice versa.Afterome xperimentatione settled n scaledvalues f cxo= -.025 and al


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644 John . Freemannd Daniel HouserTable2. Implied woState,NonsymmetricarkovChainsBetweenApproval iminishing-) andApproval nhancing+) Events

Table 2.1 Table 2.2 Table 2.3BRODY (1947-86) OSTROM & SMITH (1981-88) BRODY (1964-86)

t+ 1 t+ 1 t+ 1_ + - + - +- .32 .68 - .50 .50 - .33 .67t t t+ .38 .62 + .36 .64 + .45 .55

Several arametersemainobespecified.sexplainedntheAppendixto ourpaper Cf.fn. ) our olutionothePoliticalMotivatedllocationProblemrequires hat = ,(i + p)(lY)'. Withthe parameters escribedabove hismeanshatB .988, rthat overnmentsslightly oremyopicthanhouseholds. orour nitial nalysis,we setAPP* equalto a valueroughlyquivalento a "minimuminning"argetf 55. notherwords,we initiallyssume, ollowingoalition nd other ranches fpoliticaltheory,hat overnmenteeks omaintain ajorityupporthusmaximizingthe ains othe roupsfwhicht scomposed.Werelax his articulars-sumptionnthe ounterfactualnalyseselow.)Recall hat representshejointrealizationf theproductivity,overnmentpending,ndapprovalshocks,ndridenoteshe ransitionrobabilitiesetweenhe tates. reat-ing hese hockss independent,sing he ransitionrobabilitiesromurMarkov hains, nddefiningas before e have: 9

S4 S2 S3 S4 S5 S6 S7 S8SI .43225 .04275-~.4322504275 .00275 .00225 .02275 .00225S2 .04275 .43225 .04275 .43225 .00225 .02275 .00225 .02275S3 .31122 .03078 .55328 .05472 .01638 .00162 .02912 .00288S4 .03078 .31122 .05472 .55328 .00162 .01638 .00288 .02912S5 .02275 .00225 .02275 .00225 .43225 .04275 .43225 .04275S6 .00225 .02275 .00225 .02275 .04275 .43225 .04275 .43225S7 .01638 .00162 .02912 .00288 .31122 .03078 .55328 .05472S8 .00162 .01638 .00288 .02912 .03078 .31122 .05472 .55328

= 2.5. This parameterizationroduced or he ndependent strom nd Smith ransition atrix,simulatedpproval erieswhoseHP trend-logaluesmimickedhose f theHP trend-logf actualapproval eriesnthe1980-90period. lso, ll simulatedpproval alueswere n the nterval0,1].'9Thevalues n theHlmatrixre rounded o five ecimal laces.Recall that is definednterms f the ointrealization f the hree hocks, = (z,g,e).So, for xample,with he ymmetricMarkov hainsfor echnologynd governmentpending hocks nd thenonsymmetricarkovchain derived rom heOstrom-Smithatafor1981-88,theprobability or hetransitionromSI(Z1ow,low,low) o S2(Zhigh, high, high) s .09 X .05x .50= .00225.


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Finally,he eturnn nheritedebtnthe nitial tate, (sl), and he nher-ited evel f nheritedebt, (sO), reboth et o one.And, nitial ssets, ,are et o2.0.20Theright-handanel fTable3 reportshe arametersor he aselinemodel. hefourthndfiftholumns fTable reporthe orrespondingp-timal olicy ule; hats,howgovernmentespondsnthis olitical co-nomicworld otheoint ealizationf he espectiveets fproductivityz),public pendingg), and pprovale) shocks. or xample,he ptimal eci-sionrulemplies hatwhen 8 (Zhigh,high,high) btains, ublic uthoritiesadopt tax ate f 304 row ofTable ). Incontrast,hen acedwith6-high roductivityndhigh overnmentpendinghocks ut n approval i-minishinghock row 6 oftheTable), governmenthoosesa lowertax rateof 281.This sbecause, eterisaribus,ower axes reneeded o encour-agemorework,ncreaseonsumption,ndhence ncreasepprovalinthefaceofa surpriseecreasenthat ariable). henegativeeal nterestatereflectshe eed or essborrowingromouseholdsnthese ircumstances.Togetherhe ight airs fpolicies onstitutecontingencylanwhichminimizesovernment'siscountedxpectedeviationsromts arget,nthe aselinease,55%approval.2'Figure displayshe esults fa single imulationfthismodel. hesolid inesnthe igurere heHPtrends.achtime oint epresentsneofourpolitical-economicquilibria.22nthis articularimulation,ax nd n-20Recall hatR(sl)b(sO) s defined s thereturnn inheritedebt nthe nitial tate, 1. Onecouldthinkftheparameter as capturinghefact hat onsumer etwealths about ight imesannual ncome. ut hevalues f his arameterndofR(sl) andb(sO) sually re djusted or om-putationalurposes. f. Chari, hristiano,ndKehoe 1991.2lInsofars interestates re concerned, ecall hat ouseholds lso optimizeubject o thetransition atrixor hedifferenttates ndthat overnment ust inancetsexogenously eter-mined pending tream. he eight nterest ates nsure hat oth hings appen imultaneously.Households ake hegovernment'snterestates nto ccountnmaking ptimal onsumptionndlabor nput hoiceswhichmaximize heirxpected ate f returnivenH. Andgiven hesehouse-holdchoices nd the pending ath, heoptimalnterestates together ith heoptimalaxrates)allowgovernmento minimizehe xpectedum fapproval argeteviationsnd lsotofinancetsspending.Ifwe were nalyzing steady-state,r fourutilityunctionere inear,henegative eal

interestatesmight e counterntuitive.owever,n our et-up, hemarginal tilityfconsumptionis decreasingnd the nvironments stochastic. hereforeherewillbe a point t which hehouse-holdpreferso savefor omorrow,atherhan onsumemore oday even hought spossible hatthe utureeturnillbenegative]. nother ay o nterprethenegative eal nterestatessas "stor-age costs." ven nthepresence f uniformlyositive torage osts always egativeeturns]herewillbe a point twhich maximizingonsumer illprefero paythe ost nd consume omorrowratherhan ccrue hevery ow marginal tilityfconsumingoday.)22In ll, 200 observations ereproducedneach of the 1,000 simulations. he first 56ofthese bservations eredeletedeaving 4 likethosedepictedn theFigure1. The idea of a se-quence fpolitical-economicquilibriasakin othatwhich rescott1986a, 13) calls a sequence fmarketquilibria.


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646 JohnR. Freemanand Daniel Houser

Table3. Baseline arameterizationParameter Value

p 0.0060.9900.988y 0.6600 1.000

v -1.000ocO -0.025ocl 2.500APP* 0.550b(0) 1.000R(1) 1.000A 2.000TechnologyhockLow 0.990High 1.010

Transitionrobabilities:Low to Low 0.950Low to High 0.050HightoHigh 0.950Highto Low 0.050GovSpending hockLow 0.074High 0.078

Transition robabilitiesLow to Low 0.910Low to High 0.090HightoHigh 0.910HightoLow 0.090Approval hockLow -0.014High 0.014

Transition robabilities:Low to Low 0.500Low toHigh 0.500HightoHigh 0.640HightoLow 0.360


21/34

9 - -i

t~~~~~~~~~~~~~- \c \c cn c5H R

=~~~~~~~~~~~~~r,\m N N kn

.-t H C \ - --4 --

CQ~~~~~~~~~~~~~~~~c' ci ci c; coog ~~~ ON\

r- *) t-C c ln

v -\ / a) O o~~~~~~~~krC - k ?< ? Cl o l C, l Cl C )

o Y

PC ~ ~ ~ ClV

Q)C lCl lC Cll 400 4 o ca ' ' 6666o o6666of3 r O 0CS S m Uo

^ > > o o - OClz .) 0N 0N 0

= 'o OOO0=~~1s 0 0 0z~~~- E 34 3Zm.m33.t ?~~~


22/34

648 John . Freeman nd DanielHouserFigure . A Single imulation ith aseline arameterization

Tax Rate Interest ate0.310 - 0.10 -0.305 ... ... .... ... ...- . ... .. ... .. ... --. -...0.300. . .. .. 0.050.295 -...................... Cd0.290- . . . . . . U)1111111111111 0.10- lllllllllliiiiiiiiil

aE-0.280 . .... -0.05..

0.270 :1 :::: I :: 0.10 i1: :1:::_+H....80 81 82 83 84 85 86 87 88 89 90 80 81 82 83 84 85 86 87 88 89 90Year Year

Debt Consumption1.00 - 0.340.80 >< ~~~~~~~~~~~~~~~~~~~~0.30-------- ----- ---------- ..

0 - -. .0.6....0.00; L 0.26 .......... ......................

808 1 82 83 84 85 86 87 88 89 0 8081 82 83 84 85 86 87 88 89 90Year Year

Approval0.610.60

0.58 H H H H H?"|??l ii8| ?|?? i ...lllll80 81 82 83 84 85 86 87 88 89 90Year

terestates lowly ise nd hen all.Debt teadilyecreases.onsumptionincreasess expected. ll this ccurswhile pprovalsmaintainedithinapproximately%of he overnment'sarget.For he verall etof1,000 imulations,hemodelmimics heUnitedStatesctual ata ather ell Table ).Thedeviationsrom Ptrendn ac-tual nd imulatedogconsumptionndgovernmentxpenditureave imi-lar tandardeviations.he ame strue f he eviationsn HP trendntheactual ndthe imulatedog output.hefirstrderutocorrelationsor e-viationsnHPtrendfthe ogofgovernmentxpenditurendofapproval


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A COMPUTABLEEQUILIBRIUM MODEL 649

Table5.The BaselineModeland theDataVariable StandardDeviation* Serial Correlation*Actual Model Actual ModelLog Consumption** 0.011 0.011 0.755 0.122(0.001) (0.156)Log Government 0.013 0.017 0.464 0.575Expenditure** (0.004) (0.156)Log Approval** 0.063 0.012 0.855 0.971(0.001) (0.005)Log Output** 0.015 0.008 0.798 0.012(0.001) (0.152)Governmentxpenditure 0.233 0.235toOutputRatio (0.003)*Statisticsormodelbased on 1,000, 4 quarterimulations.mpirical tandard eviationsre nparentheses.iguresn rownine reactual atios.**Deviation rom odrick-Prescottrend.

match hose or he ctual ata s well.Theratio fgovernmentxpendituretooutputs the ame n the ctual nd imulatedata.Theonly iscrepan-cies arethe erial orrelationsfthedeviationsrom P trendn ogcon-sumptionndoutput;heresmore ersistencenthe ctual ata hannthesimulatedata or hese ariables.ut, verall,hemodel xplainshe ob-jective acts"which merge rompplyinghedecomposition ethodsfrealbusinessycle heory.Furthervidencef he dequacyf hemodelsprovidedy imulationresultsorabornput.hemodelwasparameterizedithoutny ttemptomatchhe ropertiesf he imulatedabor nputeriesothose f he ctualdata or ours. nce he inal arameterizationasdecided,his omparisonwasmade. heresults ere eassuring.n10,000 imulationshe ctual ndsimulated P trendsn oghoursmatched ell.The standardeviationftheHP deviationsn oghourswas 00717 or he ctual ata nd 00810 nthe imulatedata. his sindependentonfirmationfthe dequacyfourmodel nthe ample eriod.23

23Again,he valuationfthemodel n terms f ts bility o mimic ctual abor nput atawasdone fter heparameterizationas decided. rom he tandpointfpolitical cience, n additionalconfirmationight e tocheck he imulatedpproval atafor nit ootse.g.,Ostrom ndSmith1993). However, ote hat s a consequence f thewaywe conceive f approvalmanagement,herespectiveeries implyumpsbetween smallnumberf values Figure ). Hence uch check snotmeaningful.


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650 John . Freeman nd DanielHouserCounterfactualnalysesThe valueof an nvestigationuch s this ies n what t tellsusabouttheoreticallyignificantounterfactuals.he baselinemodel llowsustogauge hemportancefvarious tructuraleaturesf he oliticalconomyin waysthat re notpossiblewith educed ormet-ups ikeVARs andECMs,for xampleFreeman993; f. lsoBackus, ydland,ehoe1992:esp.765ff).Weshow his ere y xaminingwo uestionsf ubstantialn-teresto tudentsfAmericanoliticalconomy.hefirst astodo withheimpact fapprovalolatilitynpolicy hoice ndwelfare. he mpact fpresidentialonsensusuildings the econd. ogetherhese nquiriesearonthearger uestionfwhetheroliticalccountabilityscompatibleithmarketrocesses.ApprovalVolatilityThere smuchgreementhatpprovals subjectounexpected,eem-ingly andom hocks. nd,many fthese hocks re nternationalvents(Brody 991; Ostromnd Smith 993).24The political conomicmodelsthatreusedtostudypprovalmanagementnclude ariableshat apturethese hockscf.,for xample, lesina, ondregan,ndRosenthal993,20). Butnone fthesenvestigationsnalyze he onsequencesfapprovalvolatilityer e. Theres goodreason o do so:thenaturef nternationalrelationss rapidlyhangingndtheprospectsor uch hocks-and forshocks f ncreasing agnitudes-is definingeaturef he resent orldsystem.or xample,he1990s lready avewitnessed ore iolentnter-nationalonflictshanny ecade ince he econdworldwar,onflictshatbytheir on-stateharacteronstitute"transformationf war" GantzelandSchwinghammer994; Jung,chlitche,ndSiegelberg 994;vanCreveld,991).Unitedtatesnvolvementn nternationalonflictssthere-forenot nly ikely o continueoproduce pprovalhocks, ut lsoap-proval hocks f ncreasing agnitudes. hat mpactwill the ncreasedvolatilitynehave npolitical-economicquilibrium?hat oes uch ola-tility ean or he bilityfgovernmentoachievets pprovalarget? hatare hewelfareonsequencesf uch fforts?This counterfactualas studied yreanalyzinghemodelwith herange f approvalhocks ncreased y about 20%,more pecifically,ysettingl.w= -.03 and high= + 03.Thenewdecision ules or his ounter-factualrereportedn columns and7 ofTable4. Notice hat he ptimaltaxrates re differentrom hose or hebaseline ase.Forthe arger p-

24For xample,n theOstromnd Smith ataonwhich able 2.3 is based, bout wo hirds fthe pprovalhocks re due to nternationalvents.n the ase of theBrody ata 1991: Table3.1)all the vents re nternationalncharacter.


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proval iminishinghocks,low,he axrates re ower; or he arger p-proval nhancinghocks,high,he axrates rehigher.herange fthe n-terestatesslargernthe ase ofgreaterpproval olatilitys well.Why sthis o? Considerhe ase of he arger,pproval iminishinghocks. heseshocks eadgovernmentso ower axrates o encourage comparativelygreatermount f work. his createsmore utput nd consumptionndhence greater,ffsettingncreasenapproval. ecause heres more ut-put, heres essneed or orrowingofinancehe xogenouslyetermined,governmentpendingevels. o interestates recomparativelyower. heconversestrue orhe argerpprovalhocks ssociated ithhe igh ola-tilityase.Figure depicts single imulationor hehigh pproval olatilitycounterfactual.o establishomparabilityothe aselinease, he ame e-quence f tatessused hat roducedigure .First,otice hatnthe aceofgreaterolatilityn e governmentasmore ifficultychievingts arget.Withinive o ixyears,heevel f pprovalsabout % above he55value.Asregardshe conomic ariables,ax nd nterestates ehave sbefore,risinglowlynd hen alling.ebt gain ecreasesteadilyhile onsump-tion teadilyncreases.igure suggestshenhat igherpproval olatilitymay ot ave substantialmpact npolitical-economicquilibration.Closer tudyfthe ounterfactualodel eveals therwise,owever.Simulationf t Table6) shows hat igh pproval olatilityroduceso-cially armfulluctuationsncertainmacroeconomicariables.nparticu-lar, he tandardeviationfdeviationsrom P trendsn og consumptionand og outputredouble hose or hebaseline ase.As a result,hewel-fare fthe epresentativeouseholds slightlyower nthe ounterfactual.To be specific, igh pproval olatilityroducesbout .01%dropn thewelfare fthe epresentativeousehold.25nthisway, he nalysishowsthatmportantbusinessycles henomena"Lucas 1987) anbetraced,npart,ogovernmentpprovalmaintenancen an ncreasinglyolatilenter-nationalolity.PresidentsWho "LoveDangerously"The baselinemodel ssumed hat overnmentstriveo createwhatsessentiallyminimuminningoalitionf55%approval.ut ome overn-mentstriveormoreupporthanhis,or resumablyxcessive,onsensuallevels fsupport.hesegovernmentsftenrecriticizedor eing oo at-tached o theirpproval atingndhence or Loving angerously"The

25Thewelfare fthe epresentativeonsumers calculated yevaluatingtsobjectiveunctionin the imulations, ore pecifically,y summingts realized, iscounted resent tilityt eachpoint n time.


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652 John .Freeman ndDanielHouserFigure .A Single imulation ithHighApprovalhocks

Tax Rate Interest ate0.32 0.150.28............. .0.....QQ0.30 -0.05

cO0.29 1 -1 e -0. .... .... ......i 1co0.28 . ....... ...... - \0.10- . .. .. .. ... ....... ........ .. .. .... .. 1

0.27 . 1 .............................. .. .0.1.... ..... ............. . -15 -*....i . : 1.. .

0.26 ~ ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~...................................-.5.......... . ...80 81 82 83 84 85 86 87 88 89 90 80 81 82 83 84 85 86 87 88 89 90Year Year

Debt Consumption1.00 - 0.340.80 - ..................................................0.60 >..- -------...................................... 0.32 * .-------------- ......----- --- ---- - - - -- - - -

0.40 . . ......................................... * .0 3 - -----_--

5w ~~~~~~~~~~~~~~~~~~~~0.20 - ..... ............ ..........................E-0 2?0? ....-2..................... ... ................. 0-0 40 .. . . . .. . . . .. . . .0 26 .. . . . . .. . . . . .. . . . .-0.60 ........................ 1 2 Iliilliilliillllliilliillii-0.80 0.2680 81 82 83 84 85 86 87 88 89 90 80 81 82 83 84 85 86 87 88 89 90Year Year

Approval0.6200.610 .. ...............

co0.600 ...... ..0.590 -lll W iv lll ------li iil0.58 .. .... ,, ,.., ,.............r TT rX ||

80 81 82 83 84 85 86 87 88 89 90Year

Economist anuary4, 1991,21-4). What s the onsequence fsuchbehav-ior? s consensus uildingociallyharmful?fso, nwhatway?Thiscounterfactualas studied y setting PP* equal to 70ratherhanto thebaselinevalue of 55.26Theresultingecision ule sreportedncol-26For his ounterfactualwasreseto 3.25.Technically,hiswasdone or omputationalea-sons cf.fn. 0). Substantively,tmeans he epresentativeousehold asassumednitiallyoholdpersonal ebt oughlyine imests ncome.nrelationoourdesign, his evised alue fAprovidesa stringentvaluationf he oving angerouslyrgument-anssessmentfwhethersociety itha largenitialevel f ndebtednessanafford presidentho trives or oliticalonsensus.


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A COMPUTABLEEQUILIBRIUM MODEL 653Table6.LargeApproval hocks nd BaselineModels

Variable StandardDeviation* Serial Correlation*L.A.S. Baseline L.A.S. BaselineLog Consumption** 0.021 0.011 0.044 0.122(0.001) (0.001) (0.152) (0.156)Log Government 0.017 0.017 0.575 0.575Expenditure** (0.004) (0.004) (0.156) (0.156)LogApproval** 0.026 0.012 0.971 0.971(0.001) (0.001) (0.005) (0.005)Log Output** 0.016 0.008 0.048 0.012(0.001) (0.001) (0.150) (0.152)Governmentxpenditure 0.235 0.235to OutputRatio (0.003) (0.003)*Statisticsasedon1,000, 4 quarterimulations.mpiricaltandard eviationsre nparentheses.Figures n rownine reactual atios.**Deviation rom odrick-Prescottrend.

umns and9 ofTable4. The ndicationsre that or target f 70% ap-proval overnmentsdoptmuchower ax atesnd widerangef nterestrates hannthe aselinease. n termsfourmodel,he ower ax ates n-courage ouseholdsowork. his ncreases utputndconsumption;nturn,pprovals augmented.or xample, or he tate f owproductivityand owgovernmenthocks ndapproval iminishinghockssl), the axrate ow s 123 scomparedothe aseline ax ate f 272. n the igh ro-ductivityndgovernmentxpenditurehocks nd pprovalnhancinghockstateS8), he axrate sonly171 for he ounterfactualhereas he orre-spondingatewas 304 n thebaseline. ccordingo the olution,djust-ments reneeded n the nterestates or hedifferenttatesoenable ov-ernmentofinancets pendingnthe ace f his ew ax chedulefn. 1).Figure reportshe esultsf he omparableimulationor hismodel.Note hat overnmentsmore uccessfulnachievingtsobjectiventhiscase.Approval etswithin%ofthehigherargetalue.Thetrendn con-sumptiongainsincreasing.ut,nterestingly,he rendndebts increas-ing s well. n this espect,he ursuitf he igherpprovalargetas dif-ferentmpact n themacroeconomyhan hepursuitf the minimumwinningpprovalarget.Theresultsf he ,000 imulationsf his econd ounterfactualodelarereportednTable .They ndicatehat he ursuitf hehigherpprovaltargetH.A.T.)hasnosubstantialffectnthe olatilityf onsumptionndofoutput.eviationsnHP trendogconsumptionnd nHPtrendogout-puthave ssentiallyhe ame tandardeviationssinthe aseline ase.The


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654 John . Freeman nd Daniel HouserFigure .A Single imulation ithHighApproval arget

Tax Rate Interest ate0.18 0.10017 ... . . . . . . . . . . . . : - - - ooiIV-1-

0.05 .. .

~0.16 --.lo....L\ ----....... .. .co C4~~~~~~~~~~~~.000.15 ...... ....... U)~~~~~~~~~0.1

80 81 82 83 84 85 86 87 88 89 90 80 81 82 83 84 85 86 87 88 89 90Year Year

Debt Consumption3.00 .;< ;0.382.50 7.......................................< 0.36 . ,Y....... ..... . . . .. . . . .

0.21.50 - -- - -- - - -- - - ------ ............. . . 0 32 . . . . . . . . . ... . . . . . . .

80 81 82 83 84 85 86 87 88 89 90 80 81 82 83 84 85 86 87 88 89.Year Year

Approval0.690.69 .. . . ... . .. . . . . . . . .

0.68 .............---. -.... .....0.67Ii ilW ii; i;; l ........111il

80 81 82 83 84 85 86 87 88 89 90Year

degrees fpersistencenthese eviationsreslightlyifferent.hemaindifferences inthe atio fgovernmentxpenditureooutput.heaveragevalue fthis atio s slightlyower or he imulationsfthehigh pprovaltarget odel. gain,his ower verageatio fgovernmentpendingoout-put s associated ith udgethortfallsatherhanurpluses.s forwelfareconsequences,nthehigh pproval argetimulationsherepresentativehousehold's iscountedxpectedtilitys 7-8%higherhannthe aseline


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Table 7. HighApproval Target and Baseline ModelsVariable StandardDeviation* Serial Correlation*H.A.T Baseline H.A.T BaselineLog Consumption** 0.013 0.011 0.067 0.122(0.001) (0.001) (0.150) (0.156)Log Government 0.017 0.017 0.575 0.575Expenditure** (0.004) (0.004) (0.156) (0.156)Log Approval** 0.006 0.012 0.970 0.971(0.001) (0.001) (0.006) (0.152)Log Output** 0.010 0.008 0.079 0.012(0.001) (0.001) (0.150) (0.152)Governmentxpenditure 0.213 0.235toOutputRatio (0.002) (0.003)*Statisticsasedon1,000, 4 quarterimulations.mpiricaltandard eviationsre nparentheses.Figuresnrownine reactual atios.**Deviationrom odrick-Prescottrend.

case. So the ndications re that or he ivinggenerationt least,"LovingDangerously"-presidential ursuit f nearconsensual pproval argets-isnot ociallyharmful.ConclusionAs a means of connecting conomicandpolitical equilibration, hemodel nthispaperhas manyvirtues. irst ndforemostt achieves genu-ine theoreticalynthesis. he model fusesa general quilibrium conomywith rational, ptimizing ousehold o an approval-orientedolitywithrational, ptimizing overnment.t thus s morebalanced ndcomplete hanmanyofitscounterparts.n addition, or hefirstime,we have a politicaleconomic et-upwhich xplains uarterlyandpotentiallymonthly) quili-bration. nlikeothersnthe iterature,urmodeldoesnot imply hat quili-bration ccursonlyevery everalyears,e.g., that hepoliticaleconomicworld starts verevery ouryears."n thisregard,t s muchmorerealisticand useful han tscompetitors.hird, he tochastic atures feconomic ndpolitical rocesses reexpresslyncorporatednour nalysis. he constraintsor"lawsof economic ndpoliticalmotion" nclude andom ariables or ro-ductivity,overnmentpending, nd approval hocksand,concomitantly,agents ngage nstochasticptimization.inally, he nvestigations a meth-odologicaladvance.The analysesof the formalmodel andof the data areconsistent. orexample, he tochasticlements fthemodelare nterpretedinthe ameway nthederivationfthe gents' ptimal ecision ule s in the


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656 John . Freeman ndDaniel Houserdecomposition,imulation,nd statisticalnalysis. he investigationhushasthe ddedpayoff fanswering artels's ndBrady's 1993) and others' allfor bettermarriage fformalheorynd politicalmethodology.27Of coursethe model can be improvedn a number fways.Like theAlesina,Londregan,ndRosenthal ormalism1993, 14) and early ontribu-tions o thereal business ycle genre Lucas andStokey 1983), itdoes notinclude capital. Output s solely a function f labor input.Among otherthings, hisweakensthe ntertemporalontent f the model.28More com-plex approvalfunctions ught o be studied; heassumption hat X2 = 0ought obe relaxed o that pprovaldependsonbothnormed onsumptionand abor nput.Moregenerally,urapproval unctions disembodiednso-faras itis not connected nalytically o householddecision-making.Weneeda set-up n whichhouseholds hoose consumptionnd level of workeffortnd dispense approval imultaneously. hatwe have nowis essen-tially n approval echnologyather han fully ationalizedpproval unc-tion.There s also noprovision orheterogeneitynour set-up.Clearly, if-ferentypes f householdsmakeeconomic ndpolitical hoicesdifferently.And presidentsare more bout he pproval f some subsets fconstituentsthan hat f other ubsets. his needsto be incorporatedomehow.The polity nthe model could be enrichedn otherways.Atpresent,there s obviouslyno provision or he eparationfpowers mongdifferentpolitical nstitutionsr forelections.To the extent hat conomicpolicy-making nd the effects hereofan be tracedmoretotheexecutive han othe egislative ranchAlesina,Londregan,nd Rosenthal 993, 13) andtheobjectivefactswithwhich we are concernedhave to do withmacroeco-nomictrends, heformers not serious.Noris itclearthat he absenceofelectoral orces s problematic.t is importanto rememberhat hepresentmodeldoesquitewell nmimickingheAmerican olitical conomy t eastin thevirtual inglepartyra we study. able 5 showsthat,withoutnypro-visionfor he lections f the1980s,when theoreticallyonsistent ecom-position methodis employed,the behavior of our political-economymatches hat f theUnited tates.Also there s no evidence f anyelectoralpatternn the short nd medium erm luctuationsnapproval; or nstance,thesefluctuationsrebelow, bove, nd roughly qualtothe ong-termrend

27The aturef thismethodologicalontributions explained lsewhere. ee Freeman1993,1995).28Amongtherhings,dding apital o the roductionunctionill reate n arbitrageondi-tion hatwill imit overnment'sbility ouse the nterestate ofinancets pending. fcourse, hischangenthemodelwill lso ntroducenotherecision ariable:nvestment.racticallypeaking,adding apitalwill necessitate he pplicationfevenmore omplex olutionmethods. f. ChariChristiano,nd Kehoe 1991, esp.fn. ).


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A COMPUTABLE EQUILIBRIUM MODEL 657inapprovalndifferentlection earscf.Figure -2 ntheAppendixoourpaper; f.fn. ). Provisionsor lectoralorces ventuallyught obe made;fornstance,he sefulnessf llowing PP*tovary ver ime ughtobeexplored. ut, tmaywellbe that hepolitical ccountabilityhat s mostimportantor he tudy f democracyndmarketsccurs, ver he ong-term,hroughome onnectionetweenowfrequencyrendsneconomicandpolitical ariablesike hosewhichheHP filterapturesnd, ver heshort ndmediumerms,hroughurveysfapprovalndrelated opularevaluationsfgovernment,ot hrough hat re nfrequentlections.29i-nally, he laim hat nitarygent et-upsanbe useful otwithstanding(Lalman, ppenheimer,ndSwistak 993, 0), theresveryittle asisforthis spect fourmodel. ncorporatingifferencesnthe referencesfpar-ties nd dministrationshereforeeems ssential,speciallyfwe want oanalyze olitical-economicquilibriacross artisanras. n this ontexttis essentialhat rovisione made or he ndogeneityf pproval,articu-larlyfor hereturns hich ccrue opresidentsn terms flegislative(policy) utcomesyvirtuef heirpprovalating.It s not lear oexactly hich asks uture orkughtobe dedicated.Simply dding apitalothe resent odel nd llowingor omeheteroge-neity f households reates ometechnicalhallenges. et these re thenatural ext tepsnsofars the conomic art fthemodels concerned.Developing set-upn this ontext herebyouseholdshoose onsump-tion,abornput,nd pprovalimultaneouslynd pproval ields olicy e-turnss also a challengingask. his snecessary,owever,oachieve bet-ter ynthesisetweenconomicsndpoliticalcience. henexttep henstomodifyhemodelntheseways nd odeterminefour indingsbout heeffectsfapproval olatilityndconsensusuildingoldup. t sconceiv-able hat uch ugmentationsill ddnotust oour nderstandingfpoliti-calrealityut fmacroeconomicealitys well.30In thespirit ftheAJPSworkshop,hepresentffort as laid thegroundworkor hese xtensions.thas hown ow theoreticallyalanced,

29To eiterate,t s commonn approval tudies ofocus n a single arty/administrativera aswe have e.g.,Ostrom nd Smith 993).And,while arlyworks uch s those fNordhaus1975),Tufte1978), andHibbs 1977) claimed hat lections ad marked nd asting ffectsnthemacro-economy, he urrenthinkingAlesina 1988) holdsthat hese ffects ften re minor ndshort-lived.This s especially rue f, s is usually he ase, theres little rnouncertaintyboutwhowillwin he lection.We are ndebtedoMichaelAlvarez or he oint bout he ossible onnectione-tween ow frequenciesrendsnapproval nd nmacroeconomicariablesikegrowth.30it hould e true hat y ntroducingolitical lementsnto ealbusiness yclemodels heperformancefthose et-upswill mprove.or nstance,he owvariabilityf aborproductivitynthesemodelsmight e a result f thefailureo consider hepolitical orrelatesffiscal hocks. f.McGrattan,1994).


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658 John . Freeman ndDaniel Housertemporally isaggregated, enuinely tochastic, nd methodologically o-herent olitical-economicmodel can be built.And it has introduced newand mproved onception f political-economicquilibrium.Manuscriptubmitted6 February 996.Finalmanuscript eceived 0March 1997.

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Freeman - Houser - 1988 -- A Computable Equilibrium Model for the Study of Political Economy

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