Working Paper: CEPR ID: DP4454
Authors: Hansjörg Beilharz; Hans Gersbach
Abstract: We show that in democracies insufficient recognition of general equilibrium effects can lead to a crisis. We consider a two-sector economy in which a majoritarian political process determines governmental regulation in one sector: a minimum nominal wage. If voters recognize general equilibrium feedbacks, workers across sectors form a majority and will favour market-clearing wages. If voters only take into account direct effects in the regulated sector, workers in the other sector are willing to vote for wage rises in each period since they also reckon with higher real wages for themselves. The political process leads to constantly rising unemployment and tax rates. The resulting crisis may trigger new insights into economic relationships on the part of the voters and may reverse bad times.
Keywords: awareness of general equilibrium effects; crises; democracies; rise and fall of market distortions; unemployment
JEL Codes: D72; D83; E24; J30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Insufficient recognition of general equilibrium effects (D59) | Crisis in democracies (H12) |
| Voters disregard general equilibrium feedbacks (D59) | Support for wage increases in regulated sector (J38) |
| Support for wage increases in regulated sector (J38) | Negative consequences in unregulated sector (G18) |
| Workers in unregulated sector believe real wages will rise (J39) | Vote for wage increases (J38) |
| Vote for wage increases (J38) | Increase in unemployment (J64) |
| Vote for wage increases (J38) | Rise in tax rates (H29) |
| Political process (D72) | Drives economy into crisis (G01) |