Fiscal Discipline and Exchange Rates: does Politics Matter?

ABSTRACT

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. Our results are robust to a number of sensitivity checks, including the use of different estimators, alternative proxies for fiscal discipline and sub-sample analysis.

WITH

Carlos Mulas-Granados, IMF

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About Authors

José Tavares

Nova Faculty Affiliate

José Tavares earned his doctorate in Economics at Harvard University, where he specialized in Political Economy and Macroeconomics, and is currently professor of economics at Universidade Nova de Lisboa and Research Fellow at the Centre for Economic Policy Research (CEPR) in London.

João Tovar Jalles

Affiliate

João Tovar Jalles, a Portuguese national, is an Economist at the Fiscal Affairs Department of the IMF. Previously, he was an Economist at the OECD’s Economics Department where he was responsible for Portugal and Brazil. (...)