Fiscal Discipline and Exchange Rates: Does Politics Matter?

IMF Working Papers, November 17, 2016

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Fiscal Discipline and Exchange Rates: Does Politics Matter?

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Bibliographic details

• Authors: João Tovar Jalles, Carlos Mulas-Granados, José Tavares
• Published: November 17, 2016
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781475555769.001

Summary and central findings

• Research question: effect of exchange rate regimes on fiscal discipline, taking into account underlying political conditions.
• Theoretical model result: 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.
• Empirical confirmation: regression analysis on a panel sample covering 79 countries from 1975 to 2012 supports the theoretical hypotheses.
• Interaction finding: 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.
• Case evidence: the synthetic control method illustrates that the transition from flexible to fully fixed exchange rate under the Euro impacted fiscal discipline negatively in European countries.

Methodology

• Theoretical modeling linking political horizon and cohesion (strong politics) to fiscal performance, and explicit mechanism by which fixed exchange rates can undermine discipline.
• Empirical strategy:
  • Regression analysis on panel data.
  • Sample: 79 countries, 1975 to 2012.
  • Synthetic control method used for case illustrations of Euro-area transitions from flexible to fully fixed exchange rates.

Empirical results and robustness

• Main empirical results:
  • Strong politics → better fiscal performance.
  • Fixed exchange rates → less fiscal discipline; this negative effect can dominate the political-strength benefit.
  • Euro-area transitions to fully fixed exchange rates produced negative impacts on fiscal discipline in the illustrated European cases.
• Robustness checks reported:
  • Different estimators.
  • Alternative proxies for fiscal discipline.
  • Sub-sample analysis.
• Publication metadata and scope:
  • Authors: João Tovar Jalles, Carlos Mulas-Granados, José Tavares
  • Date: November 17, 2016
  • Pages: 30
  • Volume: 2016
  • Issue: 230
  • Series: Working Paper No. 2016/230
  • DOI: https://doi.org/10.5089/9781475555769.001
  • ISBN: 9781475555769
  • ISSN: 1018-5941

Subjects and keywords

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

IMF Working Paper by João Tovar Jalles, Carlos Mulas-Granados, and José Tavares (Working Paper No. 2016/230), November 17, 2016.

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