Fiscal Discipline and Exchange Rates: Does Politics Matter?

By João Tovar Jalles, Carlos Mulas-Granados, José Tavares

November 17, 2016

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João Tovar Jalles, Carlos Mulas-Granados, and José Tavares. Fiscal Discipline and Exchange Rates: Does Politics Matter?, (USA: International Monetary Fund, 2016) accessed September 20, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

We look at the effect of exchange rate regimes on fiscal discipline, taking into account the effect of underlying political conditions. We present a model where strong politics (defined as policymakers facing longer political horizon and higher cohesion) are associated with better fiscal performance, but fixed exchange rates may revert this result and lead to less fiscal discipline. We confirm these hypotheses through regression analysis performed on a panel sample covering 79 countries from 1975 to 2012. Our empirical results also show that the positive effect of strong politics on fiscal discipline is not enough to counter the negative impact of being at/moving to fixed exchange rates. Finally, we use the synthetic control method to illustrate how the transition from flexible to fully fixed exchange rate under the Euro impacted negatively fiscal discipline in European countries. Our results are robust to a number of important sensitivity checks, including different estimators, alternative proxies for fiscal discipline, and sub-sample analysis.

Subject: Conventional peg, Exchange rate arrangements, Exchange rate flexibility, Exchange rates, Foreign exchange, Government asset and liability management, Public financial management (PFM)

Keywords: Africa, Caribbean, Constant term, Conventional peg, Deficit, Dependent variable, Disciplines policymaker, Eurozone country, Exchange rate arrangements, Exchange rate flexibility, Exchange rate volatility, Exchange Rates, Fiscal discipline, Fiscal policy, Fiscal policy outcome, Government asset and liability management, Government coalition structure, Government transfer, Political Economy, Section III, Section VI, Section VII, Target exchange rate, Time effect, WP

Publication Details

Pages:

30
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2016/230
Stock No:

WPIEA2016230
ISBN:

9781475555769
ISSN:

1018-5941

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