The speed and force with which capital crosses national borders has led scholars and policymakers alike to question both the usefulness and practicality of fixed exchange rate regimes. While fixed exchange rate regimes provide price stability and can act as a nominal actor for monetary policy, they are vulnerable to speculative attacks as evidenced by recent events in Europe. While scholarly investigations have models to explain and/or predict the occurrence of speculative attacks, these models fail to take political uncertainty and political preferences seriously.
This research addresses two related questions regarding the political economy of exchange rate policy in the developing world. First, what role do political factors play in the process of a speculative attack? A casual glance at the political situations in East Asia provides some inductive evidence that markets react to political uncertainty. During the 1997-1998 period Korea and the Phillipines had elections and the political situation in Thailand was uncertain because the governing coalition was made up of six parts. Part of this research involves collecting data to measure political uncertainty including: the timing of elections; a change in government leadership; the effective number of parties in the legislature; electoral volatility; and, government cohesion. The researchers hypothesize that speculative attacks are more likely when there is uncertainty regarding the future of government policies.
The second question attended to in this project asks why do some policymakers devalue or abandon their currency peg while others defend its value? The decision to defend a currency's parity requires the government (monetary authority) to (1) spend foreign exchange reserves and/or (2) raise domestic short-term interest rates. These policy changes have political implications in that they may lead to higher unemployment and government debt and lower investment and economic growth. The research argues that the key factors influencing a policymaker's objective function when confronted with the decision to devalue or defend their currency's peg are determined by the country's political institutions. Leaders in a dictatorship do not face as great a risk of political loss if confronted with economic crisis. Further, politicians in countries with proportional electoral systems risk political/electoral defeat if they are forced to raise interest rates if they fail to take actions to reduce unemployment. Politicians in countries with majoritarian electoral institutions fall between these two extremes.
The research uses binomial and multinomial probit to test a number of hypotheses related to these two questions on a sample of non-OECD countries over the period 1970-1998 using yearly and monthly data. No data set currently exists that contains comparable political data on developing countries covering electoral rules, electoral institutions, party fractionalization and legislative volatility on a monthly basis. These variables are collected from sources such as Keesing's Contemporary Archive of World Events, the Country Reports and Country Profiles of the Economist Intelligence Unit, the Lijphart Elections Archive, and numerous other sources.
