Policy Responses to Speculative Attacks Before and after Elections: Theory and Evidence

Abstract

This paper investigates how electoral timing influences policymakers' responses to currency crises. Previous empirical research has shown that elections significantly influence both the probability that a currency crisis emerges and the government's policy responses to such crises. This paper provides a theoretical explanation for these empirical findings and presents a political business cycle model on exchange rate policy, in which incumbents face a tradeoff between their wish to signal competence and the high cost of exchange rate defenses in response to currency crises. The model predicts that competent incumbents are more likely to defend in response to crises occurring before elections, while incompetent policymakers always devalue. Attacks occurring after elections are predicted to result in devaluations for all types of policymakers. Several empirical implications are derived from the model and are tested for a sample of 61 developing and developed countries for the time period 1970-2003. The results support the predictions of the model and show that 1) defense is more likely before and devaluation is more likely after elections, 2) incumbents who defend their exchange rate before elections have a higher probability of being re-elected, and 3) policymakers are more likely to devalue as the intensity of the crisis increases.

Keywords: exchange rates, political business cycles, elections, speculative attacks

JEL Classification: D72, D78, F31