Political Cycles and Exchange Rate-Based Stabilization

Fixed exchange rates implemented to increase credibility and attract foreign investment, or as an alternative approach to stabilization in high inflation economies, have been shown to be successful in expanding economic activity and correcting inflation in the short term but often lead to undesirable outcomes in the medium to long term. Although there is a wealth of literature documenting the boom-bust cycles associated with the adoption of a nominal anchor, no adequate explanation has been proffered as to governments repeatedly choosing policies that are self-defeating. The authors address this question with a political economy explanation based on the notion of a self-interested government for which short-term stabilization is attractive in the face of incentives posed by the electoral cycle. If the election coincides with the boom phase of an exchange rate—based stabilization, incumbent governments increase the likelihood of gaining reelection, and the bust phase will develop, if at all, only after the contest. The authors thus suggest a modified version of the traditional political business cycle. From the standpoint of a self-interested office-seeking government, exchange rate—based stabilizations can make good political sense. Empirical results based on an analysis of eighteen Latin American countries from 1970 to 1999 support the insights of the argument: movements towards a more fixed exchange rate are greater than three times more likely in a preelection period than in other stages of the electoral cycle.