Democratic Institutions and Exchange-rate Commitments

Abstract

Since the collapse of the Bretton Woods system, countries have been able to choose from a variety of exchange-rate arrangements. We argue that politicians' incentives condition the choice of an exchange-rate arrangement. These incentives reflect the configuration of domestic political institutions, particularly electoral and legislative institutions. In systems where the cost of electoral defeat is high and electoral timing is exogenous, politicians will be less willing to forgo their discretion over monetary policy with a fixed exchange rate. In systems where the costs of electoral defeat are low and electoral timing is endogenous, politicians are more likely to adopt a fixed exchange-rate regime. Consequently, differences in domestic political systems can help account for variations in the choice of exchange-rate arrangements. We test this argument using constrained multinomial logit and binomial logit on a sample of twenty democracies over the period 1974–95. Domestic political institutions have a significant effect on exchange-rate regime choice, even after controlling for systemic, macroeconomic, and other political variables.