We construct a model of speculative trading to examine how the mean and volatility of stock prices is affected both by government partisanship and by traders' expectations of electoral victory by the right-wing or left-wing party. Our model predicts that rational expectations of higher inflation under left-wing administrations lowers the volume of stocks traded in the stock market. The decline in trading volume leads to a decrease in the mean and volatility of stock prices not only during the incumbency of left-wing governments, but also when traders expect the left-wing party to win elections. Conversely, expectation of lower inflation under right-wing administrations leads to higher trading volume. This leads to an increase in the mean and volatility of stock prices during the tenure of right-wing governments and when traders anticipate the right-wing party to win elections. Daily and monthly data from U.S. and British equity markets between 1930 and 2000 statistically corroborate the predictions from our formal model.
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