A political economy approach to multilateral conditional lending

This dissertation employs a political economy approach to study the joint determination of federal and state level policies in an economy with a federal form of governance. A formal framework is developed that captures strategic interactions between federal and state governments as well as strategic interactions between special interest groups and policymakers. This analytical framework is subsequently used to analyze the policy implications of multilateral lending under policy conditionality. In the first section of the dissertation, we consider a case in which the small economy government has access to a single instrument of policy for political redistribution. This case serves as a useful benchmark for subsequent analysis wherein each level of governance retains access to a redistributive policy tool. The results of the benchmark case illustrate that policy-making at the highest level of governance helps to reduce the extent of policy-induced distortions. Moreover, earmarking of multilateral lending for particular states of a federal economy results in the same policy outcome as the one when the multilateral loan is disbursed to the federal government. When each level of governance enjoys access to a redistributive instrument, results of the model are determined by the equilibrium relationship between the two policies. If, in equilibrium, the state-level policy behaves as a strategic complement to the policy set at the center, earmarking of the loan to the least protectionist state governments reinforces the decline in trade distortions in the economy. This leads to a higher level of social welfare in the economy as a whole. Alternatively, if the two policies are strategic substitutes in equilibrium, then although conditional lending to the federal government tends to reduce the extent of distortions caused by the federal policy, the state-level policy-induced distortions tend to rise as a consequence. In such situations, by additionally earmarking the loan to the least protectionist state governments, multilateral conditionality lending tends to contain the rise in state-level policy distortions. In the final section of the dissertation, we describe how the political and economic factors interact in a small economy and determine the government's choice between alternate policy instruments. The small economy will choose trade policy as the redistributive instrument, in the present, if expected gains from trade negotiations in a future period and the associated political support, are such sufficient to compensate for current political and economic losses.