The Disadvantage of Tying Their Hands: On the Political Economy of Policy Commitments

Incumbents are more likely to be re-elected if they have a comparative advantage in the eyes of voters on some central issue. This paper argues that incumbents have an incentive to avoid reforms that reduce the government's role in deciding these issues, in order to increase their chances of re-election. This point is illustrated in the context of the choice of an exchange-rate regime in an economy characterized by an "inflation bias". A flexible exchange rate allows the government to use monetary policy as a stabilization tool, while fixed exchange rates remove the "inflation bias" of the economy. On the one hand, it is shown that a more inflation-averse government may refrain from choosing fixed exchange rates in order to capitalize on the "inflationary" reputation of its opponent. This incentive is contrasted with the opposite incentive to "tie the hands" of the future government should be incumbent be defeated. On the other hand, it is shown that electoral considerations may reinforce the incentive of the more "inflationary" government to "tie its own hands" with fixed exchange rates.