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Session Overview
APT-5: Politics and Policy
Thursday, 24/Aug/2017:
8:30am - 10:00am

Session Chair: Francesco Sangiorgi, Stockholm School of Economics
Location: O135

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Preventing Controversial Catastrophes

Steven Baker1, Burton Hollifield2, Emilio Osambela3

1University of Virginia; 2Carnegie Mellon University; 3Federal Reserve Board

Discussant(s): Christian Heyerdahl-Larsen (London Business School)

In a market-based democracy, we model different constituencies that disagree regarding the likelihood of economic disasters. Costly public policy initiatives to reduce or eliminate disasters are assessed relative to private alternatives presented by financial markets. Demand for such public policies falls as much as 40% with disagreement, and crowding out by private insurance drives most of the reduction. As support for disaster-reducing policy jumps in periods of disasters, it may be optimal for policy-makers to propose disaster-reducing policies after disasters occur. In some scenarios constituencies may even demand policies oriented to increase disaster risk if these policies introduce speculative opportunities.

EFA2017-1202-APT-5-Baker-Preventing Controversial Catastrophes.pdf

Political Cycles and Stock Returns

Lubos Pastor, Pietro Veronesi

University of Chicago

Discussant(s): Alexander Michaelides (Imperial College Business School)

We develop a model of political cycles driven by time-varying risk aversion. Heterogeneous agents make two choices: whether to work in the public or private sector and which of two political parties to vote for. The model implies that when risk aversion is high, agents are more likely to elect the party promising more fiscal redistribution. The model predicts higher average stock market returns under Democratic than Republican presidencies, explaining the well-known "presidential puzzle." Under sufficient complementarity between the public and private sectors, the model also predicts faster economic growth under Democratic presidencies, which is observed in the data.

EFA2017-1295-APT-5-Pastor-Political Cycles and Stock Returns.pdf

Level and Volatility Shocks to Fiscal Policy: Term Structure Implications

Lorenzo Bretscher1, Alex Hsu2, Andrea Tamoni1

1London School of Economics; 2Georgia Institute of Technology

Discussant(s): Francisco Palomino (Federal Reserve Board)

We estimate a New-Keynesian model with heterogeneous agents to study the impact of level and volatility shocks to fiscal policy on the term structure of interest rates and bond risk premia. We derive three key insights from the theoretical model. First, government spending level shocks generate positive covariance between marginal utility to consume and inflation, making nominal bonds poor hedges against consumption risk and result in positive risk premium. Second, variability in the nominal term premium is caused by variation in the real term premium while inflation risk premium is remarkably stable over time. Fluctuation of the real term premium is entirely driven by government spending volatility shocks. Third, at the zero lower bound (ZLB), impact of level and volatility shocks to government spending are amplified. This is especially pronounced for volatility shocks producing substantial bond risk premium when the ZLB is binding.

EFA2017-782-APT-5-Bretscher-Level and Volatility Shocks to Fiscal Policy.pdf

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