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The Political Economy of External Discipline: Constraint Versus Incentive Effects of Capital Mobility and Exchange Rate Pegs

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  • Thomas D. Willett

    (Claremont McKenna College and Claremont Graduate University)

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    Abstract

    This paper argues that while sources of potential discipline over domestic macro economic policies such as pegged exchange rates, high capital mobility, and IMF policy conditionality are commonly viewed as constraints, it is usually more productive to view them as influencing incentive structures in a world of multiple relevant actors. From this perspective, pegged, as opposed to genuinely fixed exchange rates, are typically not an adequate substitute for domestic discipline enhancing measures. The micro level political economy analysis presented suggests serious limits to the effectiveness of external strategies as sources of discipline. Indeed, their effects can sometimes be perverse. For example, high capital mobility under fixed exchange rates can reduce short run discipline over fiscal policy and impede the ability of an independent central bank to counteract political business cycles in fiscal policy. The analysis highlights the problems of attempting to use commitment devices with asymmetric time profiles to overcome problems generated by the asymmetric short run effects of discretionary monetary and fiscal policies. In particular exchange rate pegging gives front loaded benefits and delayed costs. This makes for a particularly inefficient strategy for trying to avoid domestic macro economic time inconsistency problems. Where short time horizons greatly discount the prospective future costs of a currency crisis, the political incentives generated by pegged rates often fail to provide sufficient monetary and fiscal restraint to avoid such crises. They also tend to discourage the prompt adjustment of disequilibrium exchange rates. As a consequence, exit from a pegged regime is often delayed too long and currency crises result. Thus the political incentive structures generated by exchange rate pegging can be as great a source of difficulty for the smooth operation of intermediate exchange rate regimes as are the economic forces of high capital mobility stressed by many economists. The overall thrust of this paper is to suggest that external sources of discipline over macroeconomic policies are often weak and sometimes perverse. For many, and perhaps most countries, the primary focus for discipline should be internal.

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    Bibliographic Info

    Paper provided by Claremont Colleges in its series Claremont Colleges Working Papers with number 2001-29.

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    Date of creation: Aug 2001
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    Handle: RePEc:clm:clmeco:2001-29

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    Keywords: political economy; capital mobility; exchange rates; discipline;

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    References

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    13. Giavazzi, Francesco & Pagano, Marco, 1988. "The advantage of tying one's hands : EMS discipline and Central Bank credibility," European Economic Review, Elsevier, vol. 32(5), pages 1055-1075, June.
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    16. Ernesto H. Stein & Natalia Salazar & Roberto Steiner & Eugenio Díaz-Bonilla & Marco Bonomo & Juan C. Jaramillo & Hector E. Schamis & Alberto Pascó-Front & Piero Ghezzi & Maria Cristina Terra & José, . "The Currency Game: Exchange Rate Politics in Latin America," IDB Publications 77398, Inter-American Development Bank.
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    18. Thomas D. Willett, 2000. "The Need for a Political Economy Capability at the IMF," Claremont Colleges Working Papers 2000-55, Claremont Colleges.
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    Cited by:
    1. Christian Fahrholz, 2003. "Strategic Exchange-Rate Policy of Accession Countries in ERM II," Eastward Enlargement of the Euro-zone Working Papers wp14, Free University Berlin, Jean Monnet Centre of Excellence, revised 01 Apr 2003.

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