The Political Economy of Exchange Rate Regime Determination: Theory and Evidence

Abstract

This paper studies exchange rate regime choice from a positive perspective by modeling the interplay of monetary and fiscal policy, credibility and financial market microstructure as factors influencing the decision on de facto regime. The model shows how a small open economy reliant on foreign sources of financing is likely to opt for a stable regime. Furthermore, a stable political environment with a high degree of accountability is conducive to choosing a flexible regime. The findings suggest that flexible rather than fixed exchange rate regimes provide more fiscal discipline.

Keywords: Exchange rate regime choice, Political economy, Financial markets microstructure

JEL Classification: E63, F30, F41, G15